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The Difference Between Factoring and Accounts Receivable Financing

Accounting & BudgetingFinanceFinancing & Credit

In today’s tight credit environment, more and more companies are turning to alternative and nonbank financing options to access the capital they need to keep business running smoothly. There are a number of tools available to owners of cash-strapped businesses in search of financing. Two of the most popular are factoring and accounts receivable financing (also known as A/R financing). A lot of business owners lump the two together, but there are a few small yet important differences.

What is factoring?

Factoring is the outright purchase of a business’s outstanding accounts receivable by a commercial finance company or “factor.” Typically, the factor will advance the business between 70% and 90% of the value of a receivable at the time it purchases the receivable. The balance, less the factoring fee, is released when the invoice is collected. The factoring fee—which is based on the total face value of the invoice, not percentage advanced—typically ranges from 1.5% to 5.5%, depending on such aspects as the collection risk and how many days the funds are in use.

Under a factoring contract, the business can usually pick and choose which invoices to sell to the factor—it’s not typically an all-or-nothing scenario. Once it purchases an invoice, the factor manages the receivable until it’s paid. The factor will essentially become the business’s credit manager and accounts receivable department, performing credit checks, analyzing credit reports, and mailing and documenting invoices and payments.

What is accounts receivable financing?

Accounts receivable financing is more like a traditional bank loan but with some key differences. While bank loans may be secured by different kinds of collateral, including plants and equipment, real estate, and/or the personal assets of the business owner, accounts receivable financing is backed strictly by a pledge of the business’s assets associated with the accounts receivable to the finance company.

Under an accounts receivable financing arrangement, a borrowing base of 70% to 90% of the qualified receivables is established at each draw against which the business can borrow money. A collateral management fee (typically 1% to 2%) is charged against the outstanding amount, and when money is advanced, interest is assessed only on the amount of money actually borrowed. Typically, in order to count toward the borrowing base, an invoice must be less than 90 days old, and the underlying business must be deemed creditworthy by the finance company. Other conditions may also apply.

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As you can see, comparing factoring and accounts receivable financing is kind of tricky. One is actually a loan, while the other is the sale of an asset (invoices or receivables) to a third party. However, they act similarly in many ways. Here are the main features of each to consider before you decide which is the best fit for your company:

Factoring

  • Offers more flexibility than accounts receivable financing, because businesses can pick and choose which invoices to sell to the factor
  • Fairly easy to qualify for and is ideal for new and financially challenged companies
  • Has a simple fee structure that helps the company track total costs on an invoice-by-invoice basis

Accounts receivable financing

  • Usually less expensive than factoring
  • Tends to be easier to transition from accounts receivable financing to a traditional bank line of credit when a company becomes bankable again
  • Offers less flexibility than factoring because the business must submit all of its accounts receivable to the finance company as collateral
  • Typically requires a minimum of $75,000 a month in sales to qualify for, so may not be available to very small companies

Both factoring and accounts receivable financing are usually considered transitional sources of financing that can carry a business through a time when it does not qualify for traditional bank financing.

After a period typically ranging from 12 months to 24 months, companies are often able to repair their financial statements and become bankable once again. In some industries, however, companies continue to factor their invoices indefinitely—trucking is an example of an industry that relies heavily on factoring to keep its cash flowing.

About the Author

Tom Klausen is president at True Viking Finance, which provides creative financing solutions to small and mid-size businesses across Canada. Klausen has worked in the alternative lending industry for more than 25 years and consults with businesses struggling to obtain traditional financing. 

Profile: Tom Klausen