Accounts receivable factoring​: Definition and how it works

Offering your customers the ability to purchase on credit is a great way to grow sales and develop fruitful, long-term relationships. In some industries, it's somewhat of an expectation.

But when credit customers are slow to pay, it can put a huge burden on accounts receivable with negative downstream impacts on cash flow.

It's why many businesses choose to engage in accounts receivable factoring as a way of speeding up cash flow from credit sales.

In this article, we’ll explain what accounts receivable factoring is, the types of companies that commonly engage in it, why it is beneficial, and how to find a suitable factoring company.

What is accounts receivable factoring?

Accounts receivable factoring is a financial arrangement where a company sells its accounts receivable (unpaid invoices) to a third-party company, known as the factoring company, at a discount.

For instance, you might have an outstanding account worth $20,000. You need that cash now, so you sell the AR to a factoring company for $18,000. You receive the $18,000 right now, they assume responsibility for collecting the $20,000 from the customer, and pocket the remaining $2,000 as their profit.

Types of accounts receivable factoring

There are a few different kinds of AR factoring, including:

• Recourse factoring, where the business selling its AR is still responsible for unpaid invoices if the customer doesn’t pay.
• Non-recourse factoring, where the business is no longer responsible if the customer doesn’t pay, and the factoring company assumes this risk.
• Spot factoring, where the business sells individual invoices on an as-needed basis.
• Whole ledger factoring, where the business sells all or most of its outstanding invoices in one go.
• Advance factoring, where the factoring company provides a percentage (typically around 70-90%) of the invoice value upfront, and pays the rest, minus fees, when the customer settles.
• Maturity factoring, where the factoring company pays the business the invoice amount on the invoice’s due date, whether the customer has paid or not.

Common industries and businesses that use it 

Some of the most common industries that take advantage of AR factoring include

• Transportation and logistics, where long payment terms are long.
• Manufacturing, where delayed payments have a major impact on their ability to purchase raw materials. 
• Staffing and recruitment agencies, where the agency must pay employees or contractors weekly while clients take 30-60 days to make payment. 
• Construction and subcontracting, where payment delays are common due to approval processes and staggered project payments.
• Wholesale and distribution, where businesses often operate on thin margins, creating cash flow challenges. 
• Healthcare and medical services, where reimbursements from insurance companies and government programs are often delayed 

How does accounts receivable factoring work? The step-by-step process Here’s what the accounts receivable factoring process looks like from start to finish:

1. The business provides goods or services to a customer and issues an invoice with payment terms (e.g. net 30 days).
2. The business applies for factoring.
3. The factoring company evaluates the application and approves it.
4. The two parties sign a factoring agreement outlining terms, fees, and conditions.
5. The business submits invoices to the factoring company for funding.
6. The factoring provides funds in alignment with the agreement.
7. The factoring company takes over responsibility for collecting payments from the customers directly. 
8. The customer pays the invoice in full.
9. The factory company transfers any remaining balance to the business, minus any fees.

Role of a factoring company in the process What roles does the factoring company take in AR factoring?They take care of:

• Assessing the creditworthiness of the business’s customers to understand the risk of default
• Providing immediate cash to a business that is selling its accounts receivable
• Collecting payments directly from the customer
• Assuming the risk of customer non-payment (in non-recourse factoring) 
• Tracking payment statuses and providing updates to the business
• Deducting its fees and charges and remitting any remaining balance to the business 

Calculating accounts receivable factoring

Let’s now take a look at how accounts receivable factoring is calculated.

Formula for calculating the advance rate 

The advance rate is the percentage of the invoice value that the factoring company will pay upfront. This rate is determined based on the invoice amount, perceived risk, payment terms, and other factors such as the relationship between your business and the factoring company.

The formula for calculating the advance payment amount is:

For example, if you have an invoice worth $50,000 that you’d like to factor, and your AR factoring company offers an advance rate of 80%, the calculation would look like this:

$50,000 x 80% = $40,000

This means you’ll receive $40,000 upfront.

Determining the discount fee 

The discount fee is the cost that the factoring company charges for its services.

It’s calculated using the discount rate, which is a percentage determined by a variety of factors, including their own standard rates.

To determine the discount fee, we use this formula:

For example, if the invoice value is $50,000, the factoring company takes 2% per month, and the invoice isn’t due for another 60 days, the calculation will look like this:

$50,000 x 0.02 x 2 = $2,000

In this case, the factoring company takes a $2,000 fee.

Total cost and final payment 

Finally, we need to consider the total cost and final payment.

The total cost is the discount fee, in this case, and the final payment is calculated as such:

Final payment = Invoice value - (Advance payment + Discount fee)

In our example, the invoice value was $50,000, the advance payment was $40,000, and the discount fee charged by the factoring company was $2,000.

So, we calculate:

$50,000 - ($40,000 + $2,000) = $8,000

This means that once our customer pays their bill in full, the factoring company subtracts its $2,000 fee and pays us the remaining $8,000 as the final payment.

Benefits of accounts receivable factoring 

Why engage in AR factoring?

Here are 10 of the most important ways in which businesses benefit from selling their accounts receivable:

1. Improved cash flow and working capital
2. Reduction in bad debt risks
3. Flexibility and scalability for fast-growing businesses
4. Faster access to funds than traditional financing options  
5. No additional debt
6. Streamlined credit management
7. Effective for seasonal or cyclical business
8. Better supplier relationships 
9. Lower administrative costs
10. Increased predictability in financial planning 

Choosing an accounts receivable factoring companyThinking about finding a factoring company to purchase your AR? Here’s how to go about it.Key considerations when selecting a factoring partner This is what you need to think about when selecting a factoring partner:

• The fees and costs involved included the discount rate and any additional charges such as transaction fees
• The advanced rate offered upfront 
• Whether you want to engage in recourse or non-recourse factoring
• Whether the factoring company has expertise in your industry
• The customer service and level of support provided by the AR factoring company 
• How good the reviews and reputation of that company are
• The contract terms such as volume minimums or exclusivity requirements
• How quickly the factoring company can process invoices and disburse funds
• What kind of online tools does the company provide for managing accounts, tracking payments, and generating reports 

Questions to ask potential factoring companies Here are a few questions you should consider asking when considering working with a potential factoring company:

• What are your fees and rates?
• What is your advance rate?
• How long does it take to get funding?
• Do you have a minimum volume requirement?
• Do you offer recourse or non-recourse factoring?
• Do you work with businesses in my industry?
• What other contract terms should I be aware of?
• How do you handle customer collections?
• Do you provide any online tools for tracking and reporting?

Get on top of accounts receivable with BILL AR factoring is one way to improve cash flow and remove some admin burden from your AR team. It's not the only solution, though.BILL, our accounts receivable automation platform is stacked with features for improving AR efficiency, such as:

• Automated invoicing
• Scheduled follow-ups
• Multiple payment methods
• Integrations with the rest of your finance tech stack

‍Get started with BILL today and make accounts receivable work for you.