Factoring Accounts Receivables or Asset Based Loan Financing
When a business goes over budget and is short on cash, they often turn to their local bank for an asset-based loan. They may also consider factoring accounts receivables (AR) for some quick cash. Which is a better option, a loan or factoring accounts receivables? This article looks at the advantages and disadvantages of these two types of cash procurement. First it’s important to understand accounts receivable factoring.
What is Accounts Receivable Factoring?
In simple terms, factoring accounts receivables (aka. invoice factoring) is when a third party (the factor) buys a company’s accounts receivables. This differs from a typical loan because the money received from the factor does not have to be paid back. There are usually three parties involved, including the:
- seller (company that’s selling the accounts receivables)
- debtor (company’s customer)
- factor (company that’s buying the accounts receivables)
What are the Costs of Accounts Receivable Factoring?
The factor charges the seller a fee and the factor is generally responsible for collections. The fee can vary depending on various factors like the credit worthiness of the debtor, the dollar amount factored and average days to payment, just to name a few. The fee is generally known as a discount.
The actual amount advanced to the seller is often a percentage of the total invoices sold. For example if 75% of the total invoices are advanced in cash, the seller will receive the 25% difference once the invoices are paid. The percentage of the advance can also have an affect on the fee or discount. The lower the percentage of the advance, the lower the discount amount.
Invoice Factoring vs. Asset Based Loans
Accounts receivable factoring can have some advantages over a typical business loan. If a business loan can be paid back relatively fast, limiting the amount of interest paid, invoice factoring may not be that advantageous. The terms on a loan versus the fee for invoice factoring must be carefully considered for the best financial option.
Invoice Factoring Advantages
- Cash advanced is typically much faster
- No money has to be paid back
- Seller’s creditworthiness not usually a factor
- Debt collection performed by third party (factor)
Invoice Factoring Disadvantages
- Fees are associated with debtor’s creditworthiness
- Customer (debtor) satisfaction issues dealing with third party (factor)
If the factor uses aggressive debt collection practices, this could create customer satisfaction issues. It could even get to the point where they will cease to conduct business with the company. If a debtor’s creditworthiness is poor and/or they make late payments, these factors could increase the fees for invoice factoring to the point where it’s a disadvantage compared to a business loan.