If you own a small or medium-sized business that relies heavily on customer invoices, you understand how financially devastating slow-paying customers can be. Slow-paying customers might wait sixty or ninety days before paying their invoice, leaving your business with a sizable hole in its balance sheet while you wait.
Spread this across several customers, and you’ll see how this can become a cash flow crunch for small and medium-sized businesses. Luckily, there are two funding options available to businesses with slow-paying customers.
Accounts receivable financing and accounts receivable factoring are two funding methods that use the invoices in your accounts receivable to fund your business with upfront cash. However, you’ll need to be aware of the major differences between the two to determine which financial service is best for your business.
In this post, Great Funds Factoring will explore the major differences between A/R financing and A/R factoring. Great Funds Factoring helps small and medium-sized businesses improve their cash flow and fund growth through invoice factoring services.
Discover how we grow businesses and fill out our contact form. Or, if you are ready to start, fill out a credit application today.
Defining Account Receivables Factoring
A/R factoring, also known as invoice factoring, is a financial service whereby a business sells its invoices to a factoring company at a slight discount. The business receives a lump sum of cash upfront, and the factoring company keeps the total amount of the invoices once customers pay.
The lump sum of cash is a discounted percentage of the total invoice amount minus a reserve, which is paid out after the invoices are paid in full.
Check Out This Scenario—
You have $20,000 in unpaid invoices. You then sell these invoices to a factoring company that holds 10% in reserve until the invoices are paid in full.
From this 10% held in reserve, the factoring company charges a factoring fee, which is partially determined by the amount of time the invoice is outstanding, in addition to other factors.
10% of $20,000 = $2,000 reserve
You’d receive $18,000 upfront and an additional $2,000 (minus the factoring fee) from the factoring company once the invoices are paid.
Once your customer pays their invoice, you’d receive the $2,000 reserve – factoring fee.
Invoice Factoring and Factor Fees
So, what goes into the factoring fee? There are several items factoring companies consider when determining the fee. As a result, the factoring fee is often different for different customers of the factoring company.
The factoring fee is determined by the following components—
- The number of outstanding invoices being factored
- How long it takes your customer to pay their outstanding invoice
- The total amount of the outstanding invoices
- Your business’s sales volume/amount of work coming in
- Your business’s industry
- Your business’s creditworthiness
What is the Reserve?
The reserve is an amount the factoring company holds as security if the customer doesn’t pay their invoice. Like the factoring fee, this amount is determined on a case-by-case basis.
What are Recourse and Non-Recourse Factoring?
There are two main types of invoice factoring—recourse and non-recourse. In brief, with recourse factoring, your business is on the hook if your customers do not pay their invoices. With non-recourse factoring, your business is not on the hook if they do not pay.
To learn more, check out our post on recourse and non-recourse factoring.
Defining Account Receivables Financing
Accounts receivable financing is a financial service offered by banks in which a bank issues your business a loan using your unpaid invoices as collateral. The loan amount is a percentage of the total invoice amount.
These loans collect interest and are paid back over time in either weekly or monthly installments. There are also financing fees charged for every week your customer doesn’t pay their invoice.
Bank Loans With Your Invoices as Collateral
With accounts receivable financing, the loan is typically 75% – 85% of the total invoice amount being offered as collateral. So, if you want to finance $20,000 worth of invoices, you’ll likely receive $15,000—$17,000 worth of the total invoice amount.
Accounts Receivable Financing Accrues Interest
While you are paying back your loan, the principal will accrue interest. The interest rates for A/R financing vary considerably and are based on several factors similar to what determines the factoring fee for invoice factoring—
- The number of outstanding invoices you want to finance
- The total amount of the outstanding invoices
- Your business’s sales volume/amount of work coming in
- Your business’s industry
- Your business’s creditworthiness
- Your customer’s creditworthiness
- How many loans your business already has taken out
The interest rate varies considerably, with some being as low a 1% and others as high as 5%. A finance company usually charges a financing fee for every week your customer doesn’t pay their invoice. This fee can be as high as 2%.
If you finance an invoice worth $10,000 and the financing fee is 2%, you are losing 200 dollars for every week your customer doesn’t pay, and that’s in addition to the interest and payment installments you owe back to the bank.
Four Major Differences Between an A/R Financing and A/R Factoring Company
Though both financial services use your business’s invoices, there are key differences between invoice factoring and invoice financing that you need to be aware of—
- Invoice Factoring is Not a Bank Loan
Invoice factoring is not a bank loan. You do not owe interest on the total amount, and there are no monthly payments. Generally speaking, it is much easier and takes much less time to get approved for invoice factoring than it does with traditional loans.
- Factors Help With Payment Collections and Customer Management
Another major difference between invoice factoring and invoice financing is that a factoring company handles collections. This is because they’ve purchased your invoices and are responsible for ensuring they get paid.
With invoice financing, you still own your invoices and are responsible for making sure they get paid. In this case, the invoices are simply the collateral for the loan amount and are not owned by or managed by the accounts receivable financing company.
- Businesses Retain More of Their Total Invoice Value Through A/R Factoring
As discussed above, many factors go into determining the discount fee or the loan amount with invoice factoring and invoice financing. However, invoice factoring is generally less expensive than invoice financing. In general—
- Accounts receivable factoring offers businesses 95% to 99% of the invoice amount
- Accounts receivable financing offers businesses 75% to 85% of their invoices with interest
- The Cash From Invoice Factoring is Not Debt–The Cash From Accounts Receivable Financing Is
Another difference is that the cash received from factoring isn’t debt, whereas the cash received from accounts receivable financing is debt. With invoice factoring, the cash wired to your business doesn’t have to be paid back and doesn’t accrue interest.
Which Financing Option Fits Your Business Better?
A/R financing and A/R factoring are two solutions to the same problem—unpaid invoices that create cash flow issues for your small or medium-sized business. Consider the following key differences when determining which solution is best for your business and that stack of unpaid invoices.
Factoring companies help with collections and customer management. Banks do not. If you like to handle collections and your business has a dedicated collections system, this point might not resonate with your business’s needs. However, for businesses that could use the extra help collecting and managing customer payments, factoring companies provide that service.
The money received from factoring is not a loan, doesn’t accrue interest, and doesn’t need to be paid back, whereas the money from A/R financing is a loan, does accrue interest, and does need to be paid back.
Generally, businesses retain a higher percentage of their original invoice value when they use invoice factoring instead of invoice financing. To learn more, check out our post on the benefits of invoice factoring for small and medium-sized businesses.
For a near-immediate solution to cash flow problems, invoice factoring
Great Funds Factoring Helps Businesses Grow with A/R Factoring
Great Funds Factoring helps small and medium-sized businesses flourish and grow with our invoice factoring services. If you are interested in learning more about how we help improve cash flow, get in touch with us or fill out a credit application today!