Accounts Receivable Financing vs Factoring

Michelle Adams

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It’s hard to run a business. Surprisingly, one of the hardest parts of running a business is getting paid for the goods or services you provide. Most consumers don’t think about this. But there’s actually a lot of steps between doing business and getting paid.

It’s pretty clear how businesses that work with other businesses might have problems with cashflow. These kinds of businesses usually use and invoice-based payment model. That means you bill for your goods or services upfront. Then, the customer has a set period of time to pay.

However, you still need to operate and do business while you’re waiting for payment. Moreover, it’s common to give clients 30 days to pay the invoice. Some industries have an even longer expectation. They regularly offer terms of 60, or even 90 days.

That can leave your business facing a cash crunch. There are options. But many of them have lots of risks. For example, loans and credit cards charge interest rates. They also generate debt. Also, new businesses might not be able to use these products because they don’t have an established credit history.

As a result, getting a business off the ground and running can seem impossible. You need a huge supply of liquid capital to ensure your business runs smoothly while you wait to get paid. That slows down your growth. It also makes it hard to plan for the future. However, there’s more options for businesses to consider.

Two popular options for maintaining your cashflow to meet operating expenses are receivables financing and invoice factoring. Both of these solutions have something in common. Namely, they use the assets you already own, your accounts receivable, to generate immediate cashflow for your business.

This piece will look at accounts receivable financing and invoice factoring. We’ll explain what each one is. We’ll also cover the pros and cons of each option. Use this information to make informed choices about how to best get your business running smoothly.

What is Receivables Financing?

Receivables financing, or account receivables financing, is a way to generate cash for your business. It’s a specialized kind of loan. You borrow money against your accounts receivable. That’s money that your customers and clients already owe your business.

That’s what sets receivables financing an invoice factoring apart from other cashflow solutions. You use the money customers already owe you to pay for expenses. These methods let you do that even if your customers or clients haven’t paid their bill yet.

It’s important to note that receivables financing is kind of a vague term. Invoice factoring is actually a specific type of receivables financing. That means you might find it described as such in other places. For this article we’ll use the term receivables financing to specifically mean a loan against your receivable assets. That’s a bit different than invoice factoring, but we’ll cover that later. 

Accounts Receivable Financing vs Factoring

Understanding Accounts Receivable Financing

Getting financing against your receivables is a viable solution for businesses trying to grow. After all, if you have accounts receivable, then you’re already doing business. We’ll go over the basics of receivables financing, as well as its pros and cons here.

What is it?

Receivables financing is a specific type of asset-based loan, or ABL. However, instead of using stock, equipment, or other capital as collateral, you use your accounts receivable.

One main difference between receivables financing and invoice factoring is that, with receivables financing, you still retain ownership of the asset. If you don’t repay the loan, then the lender can collect on the invoice and take the client’s payment to cover the balance.

Pros of Receivables Financing

There are several benefits to receivables financing. The first is that you’re able to quickly get cash to run or grow your business. Using receivables assets as collateral means that it’s easier to secure a loan. This is especially important for new businesses. It lets you get financing even if you don’t have an established credit history.

Another benefit of receivables financing is that, by using invoices as collateral, you protect your core business capital. Other types of asset-based lending use vital equipment or property as collateral. That means if you don’t pay your bill, you might lose something that’s essential to running your business.

Also, many lenders request part ownership of the company as collateral. Therefore, if you don’t pay your bill you can lose your company. That’s a huge risk. Accounts receivable financing resolves that risk.

Because the collateral asset is the accounts receivable, the rest of your business is protected. If you can’t repay the loan, the only thing you lose is the right to collect on the receivable assets you put up for financing.

Additionally, you generally get a higher loan-to-value ratio, or LTV, for receivables financing. With other types of ABLs you might only get 50% of the asset’s value. However, receivables financing generally offers at least 80-90% of the value of the invoice. That means more money in your pocket to run your business.

Receivables financing also disburses funds faster than other kinds of loans, including other ABLs. You can establish a relationship with a lender. Many lenders have an automated system. You simply submit the invoices you want to borrow against, and you get funded the same or next day according to the terms in your agreement. When the invoice gets paid, you pay back the loan.

Cons of Receivables Financing

There are a few drawbacks to receivables financing. First, the primary liability for default is still on you. That means if your customer or client doesn’t pay their bill, you still owe the loan. You’ll want to closely review the terms of any ABL arrangement. Some companies add additional penalties that could cost you lots of money if you don’t pay on time.

This is also an issue because it places your ability to repay the loan outside of your control. Your ability to repay depends on your clients operating successfully so that they can repay you. If one of your clients closes shop while you have an outstanding invoice with them, then you’re on the hook. Therefore, you need to trust your clients and their ability and willingness to pay for receivables financing to make sense for your business.

The fact that primary default liability lies with you means that you’re facing a higher risk with invoice financing than you would with a factoring service. For some industries and businesses, the risk is worth it. For others, factoring might be the best option. We’ll look at invoice factoring now so you can make an informed choice.

Accounts Receivable Financing vs Factoring

Understanding Invoice Factoring

Invoice factoring is a way to use your account receivables to generate immediate cashflow. The biggest difference between invoice factoring and receivables financing has to do with who owns the assets. This plays an important role for some types of businesses, so let’s cover the basics.

What is it?

With receivables financing, you retain ownership of the assets. When you factor an invoice, you sell the receivable to another company. That means you don’t have the default liability for the invoice anymore. This leads to its own set of pros and cons.

The process works similar to receivables financing. When you factor an invoice, the company providing the capital buys it. That means that it’s their job to collect on the invoice. You get a set amount of funding no matter what. This can be from 75-95% of the invoice’s value. You get the rest of the receivable’s value, minus a discount fee, when the client pays the invoice.

Pros of Invoice Factoring

The pros of invoice factoring, compared to receivables financing, center on the fact that you don’t have default liability for the invoice. This has several implications.

First, if your customer doesn’t pay the invoice, then it’s the factoring company’s problem, not yours. You still get to keep your initial funding. That greatly lowers the risk you face. As a result, it offers a level of security that you can’t even get if you just collect directly from your clients.

This is also a benefit for newer businesses. Many businesses have a hard time getting financing when they don’t have a credit history. Invoice factoring resolves this. The factoring service isn’t interested in your credit. Instead, they check the credit of your clients. After all, they don’t need you to pay any bills. They need your client to pay.

Another benefit is that you can set up an agreement with an invoice factoring service. This allows you to quickly submit invoices. You can usually get funding on your factored invoices within 24 hours. That allows you to have the cash on hand you need to run your business.

Finally, there are many factoring companies that work with specific industries. These companies offer a range of benefits and services in addition to invoice factoring. For example, invoice factoring is common in the trucking industry. Many trucking factoring services also offer things like fleet fuel cards and other perks. These extra services allow you to consolidate a lot of your accounting with one service provider. You also might be able to cut your operating expenses by getting a discount for using multiple services.

Cons of Invoice Factoring

There are some drawbacks to invoice factoring. The biggest benefit is also one of the biggest drawbacks. Namely, you don’t own the invoice you generated. That means the client doesn’t pay you. Instead, you need to direct them to pay your factoring service.

This can put off some customers. They might think your business is having financial problems. They also might think that your business is some kind of a scam. This isn’t usually a problem in B2B businesses, as other companies will understand invoice factoring. However, if you deal with the general public, then factoring your invoices might make it harder to establish a reputation as a trustworthy business.

Another problem comes with the fine print. Some companies charge a compounded discount fee. That means that you get less of your invoice’s value the longer it takes your customer to pay. You don’t have any power over when your customer pays their bill.

 Moreover, they might not pay their bill because they don’t recognize the invoice factoring company is charging for your goods or services. That can lead to awkward situations with your clients.

The fact that the invoice factoring service checks your client’s credit scores can also be a drawback. If you deal with other new businesses, or if you deal with high-risk businesses, then you might not qualify for factoring.

Additionally, your client’s credit scores can influence the terms you get on your factored invoices. That can result in you getting a smaller initial payout and a larger discount fee. Functionally, you lose out on money because your clients have made credit mistakes in the past. This can be a frustrating situation.

Some factoring companies require you to factor all of your invoices with them. These kinds of arrangements can put a dent in your overall bottom line. After all, you have to assume that you’ll pay the discount rate on any invoice you generate.

Finally, invoice factoring means that you’re not getting the full value of your invoice. Depending on the terms of your agreement and profit margins, you can actually hurt your business’s growth. That’s one of the reasons why it’s important to carefully crunch all the numbers before you sign up for a factoring service. The appeal of fast operating capital is very strong. But you can’t let that cloud your judgement when it comes to your bottom line.

 

As you can see, there are many pros and cons when it comes to using your receivables in innovative ways to grow your business. However, it’s important to make sure you carefully weigh the pros and cons of the different choices. That’s the only way to ensure that you’re getting the best value for your business. No matter which option you choose, receivables financing and invoice factoring both offer a way to ensure you’ve got the cashflow you need for your business.

Michelle Adams
Business Consultant

Michelle worked at a teller at her local bank while she was earning her degree in economics. Then, after completing an MBA, she came back to the bank as a loan officer. As a result, Michelle is uniquely suited to providing advice to small businesses when it comes to selecting the best loan and credit products.