Accounts receivable (A/R) factoring, often referred to as invoice discounting, is a type of short-term debt financing used by some business borrowers. The transaction takes place between a business (the borrower) and a lender (often a factoring company as opposed to a traditional commercial bank).
Factoring is only available as a funding source for companies that sell on credit terms, meaning that a borrower (the vendor) sells a good (or service), generating an invoice to its buyer for payment at a later date (terms may be 30, 45, or 60+ days). This expected future payment sits as an account receivable (a current asset) on the vendor’s balance sheet.
A management team may choose to sell or assign this account receivable (or a specific invoice) to a factoring company at a discount to its face value in exchange for cash. The transaction permits the borrower to have cash today instead of waiting for the payment terms to be settled in the future.
Aside from the advantage of getting cash upfront, accounts receivable factoring is also commonly employed as a strategy to transfer payment risk to another party (in this case, the factoring company).
Accounts receivable factoring is a source of debt financing available to businesses that sell on credit terms.
The borrower assigns or sells its accounts receivable (or specific invoices) in exchange for cash today.
A/R factoring is more expensive than a traditional bank line of credit but offers higher advance rates and greater flexibility around the uses of the loan proceeds.
How Does Accounts Receivable Factoring Work?
A borrower’s management team assigns or sells the account receivable at a discount to its face value. The cash amount is expressed in percentage terms and is referred to as the “advance rate.”
An advance rate can be thought of as a “loan-to-value” and it’s derived in a similar way to how a “borrowing base” or a “margin rate” might be calculated on an operating line of credit by a more traditional commercial lender.
A 90% advance rate on a $100,000 invoice would mean the factoring company wires the vendor $90,000 (90%) today, then remits the difference (less its interest charge) upon collection of the invoice from the vendor’s customer at the end of the invoice period.
Accounts Receivable Factoring vs. Traditional Operating Line of Credit
Both A/R factoring and operating lines are considered forms of post-receivable financing, meaning an invoice has been generated (as opposed to Purchase Order Financing, which is pre-receivable). Assuming a commercial borrower qualifies for both, why might management choose one over the other?
There are advantages and disadvantages to both, best illustrated when measured against the following dimensions:
Rates can vary considerably based on a borrower’s risk, but in general, an operating line of credit will cost between 1% and 3.5% over the lender’s “Base Rate” (like bank prime), meaning an all-in annual interest rate of ~4% to ~9% depending on the jurisdiction and the rate environment. Factoring, on the other hand, will often cost 1.5%-3% per month (for an annualized rate of 20%-45%).
Duration of the exposure
While subject to annual reviews and margining requirements, a bank operating line is usually extended to revolve on an ongoing basis, as long as the lender can remain comfortable with the borrower’s risk profile. A/R factoring exposure generally only lasts as long as the vendor’s payment terms with its buyer (usually 30-90 days).
A bank line of credit will generally advance up to 75% of good accounts receivable (meaning under some aging limit–usually 60 or 90 days). Many factoring companies will offer an advance rate of 75-90% of an invoice’s face value. This higher advance rate is considered attractive by many borrowers and might justify the higher cost.
Purpose of loan proceeds
A bank’s line of credit is used for “general working capital” support. This means it bridges a borrower’s working capital funding gap; it would usually be frowned upon (or even restricted) to use the proceeds to fund a dividend, for example.
Factoring, on the other hand, often has very few restrictions on the uses of loan proceeds. This flexibility is another reason many borrowers might be willing to pay a premium.
Types of Accounts Receivable Factoring
Broadly speaking, accounts receivable factoring can be categorized as follows:
1. Recourse vs. Non-Recourse Factoring
Recourse means that should a borrower’s customer not pay, the factoring company will retain “recourse” over the borrower (the vendor), meaning they can demand repayment. Non-recourse factoring means that the factoring company is out of pocket should the vendor’s buyer not settle its invoice.
2. Notification vs. Non-Notification
In a notification deal, the borrower’s buyer would be notified of the transaction, meaning that the company’s payable team would be contacted with new payment instructions by the factoring company. In a non-notification deal, the buyer is completely unaware of the vendor’s financing arrangement with the factoring company.
3. Regular vs. “Spot”
In a spot deal, the vendor and the factoring company are engaging in a single transaction. In what’s called a regular factoring arrangement, the factoring company will have an ongoing relationship with its borrower and they likely have an approved limit, which can be drawn, repaid, and redrawn again – based on newly issued invoices.
All else being equal, regular, recourse, and notification deals are less risky for a lender (or a factoring company); non-recourse, non-notification, and spot deals are more risky.
What Types of Businesses Employ A/R Factoring?
While accounts receivable factoring is most frequently used by smaller businesses, it can work with any type of company (as long as it sells on credit terms). However, it is very common in a smaller subset of specific industries, where:
Collection times are long or unpredictable – like independent trucking and logistics companies.
Collections and disbursements are uneven – like temporary staffing agencies, where employees are paid bi-weekly by the agency but its invoices may only be settled by the employer monthly (or longer).
Invoice settlement is dependent upon a different party in the value chain settling its invoice – like with Construction sub-trades (plumbing, framing, HVAC, etc.); tradespeople complete work today but are only paid by the general contractor (GC) once the project owner or the real estate developer settles its invoice with the GC.
Thank you for reading CFI’s guide to Accounts Receivable Factoring. To keep advancing your career, the additional CFI resources below will be useful:
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