When it comes to understanding the differences between accounts receivable financing and factoring, it can get pretty confusing. Some resources will use both terms as if they are interchangeable, though they are not. While the services carry plenty of similarities, understanding the nuances of each and deciding which is a better option for your business will benefit your operations in the long run.
What is Accounts Receivable Financing?
Accounts receivable (AR) financing, sometimes referred to as invoice financing, is a commercial lending structure that can help improve a business’s cash flow and access to working capital. With AR financing, a company can receive advances on the revenue from unpaid invoices, while maintaining ownership of the invoice and collections process, and allowing the bank or other lender to leverage outstanding AR as collateral against the loan.
If you enter into an AR financing relationship with a bank or other lender, you will provide the details of your company’s accounts receivable and the invoices that will be monitored as collateral. The financing firm will provide you a percentage of the outstanding AR as a cash advance, which you will then make regular payments to pay off as you collect on the invoices due.
Accounts receivable financing is typically used by businesses that are in turnaround or quick growth periods but do not have the assets or credit profile to qualify for traditional business loans. Industries that experience seasonality are also often a fit for accounts receivable financing because it provides flexible working capital when the company is not regularly receiving payments.
Pros:
- Provides a quick source of cash flow
- Maintains revenue stability
- Complete ownership of collections (no change in customer experience)
Cons:
- Rates often higher than traditional business loans
- Pricing and fees can vary by lender
What is Factoring?
Factoring is a way to get quick cash flow by selling an outstanding invoice to a lender (the “factor”). Factoring is used by businesses who need cash for working capital sooner than their customers are anticipated to pay off their accounts receivable.
If you choose to establish and utilize a factoring relationship, the factor will purchase your invoices awaiting payment and will typically pay you between 70-90% of its value as an advance. Your customer will then pay the amount due directly to the factor instead of paying your business. Once the lender has received full payment from the customer, they will provide you the remaining balance minus a small fee. Because factors are paid by the customer instead of your company, they are usually more invested in your customer’s payment reliability than your own business credit score.
Factoring is a great option for companies that have reliable but slow-paying customers, want to expand operations, are in a start-up growth phase, or experience seasonality.
Factoring can be a way for new businesses to gain access to cash flow quickly because the factor is primarily concerned with your customer’s creditworthiness. If your business does not have established credit, but your customers do, factoring can be a way to access additional working capital to invest in your company’s operations.
Because customers pay a third party directly, factoring can sometimes be interpreted as a signal that your company is experiencing cash flow issues. Ensuring the factor you choose is easy to work with on the customers’ end will help to mitigate concerns. If your customers feel hassled as they pay your factor or become nervous about the financial health of your company, it may deter them from pursuing future opportunities with your business.
Pros:
- Does not affect debt-to-equity ratio (factoring is an asset purchase, not a loan)
- Provides quick access to cash flow
- Great for companies with little or poor credit history
- No need to manage collections (factor will take care of that)
Cons:
- Some factors may have costly fees – be sure to ask upfront
- May impact customer experience – factors should be selected carefully
What is the Difference Between Accounts Receivable Financing vs Factoring?
The main difference between accounts receivable financing and factoring lies within the ownership of the invoice. With accounts receivable financing, your company maintains ownership of the invoices, and they are simply used as collateral toward the loan. With factoring, the factor purchases the invoices and is responsible for collecting the receivables.
Which Should I Use?
Invoice financing and factoring are both notable alternatives to traditional bank loans. These options carry less risk, as normal loans and lines of credit are based on expected/historical sales. These financing options are based on actual revenue because services have already been rendered and invoices have been issued. Invoice financing and factoring are also quicker processes, whereas lines of credit and loans take longer to get approval – potentially stifling business operations.
Factoring is a great option for small businesses that need cash flow while waiting for their customers to repay them and would like to transfer the responsibility of collecting the accounts receivable to a third party.
AR financing is a fantastic choice for larger, established businesses that need cash flow and would like to maintain responsibility for the invoices. If you feel confident you can make regular payments on the loan, AR financing is a great way to avoid customers perceiving a potential cash flow issue in your business while still receiving advances on your AR.
When it comes down to deciding which option is right for you, consider your business structure and the nature of your customer payments and creditworthiness. Look into lender/factor options and determine which will be best for you financially in the long run; some lenders may have higher fees or interest rates than others.
TAB Bank is an award-winning bank that offers a plethora of commercial banking solutions including AR financing and factoring. Learn more about how TAB Bank can help you find long-term, secure, and accessible banking services to grow your business.
