Factoring transactions can be either recourse or non-recourse. In a recourse transaction the company selling its receivables must repay the advance and the factor’s fees if the customer does not pay the invoice by the recourse date, which is usually 90 days after the invoice date. In a non-recourse transaction the factor assumes the risk of non-payment. Recourse and non-recourse terms refer to the risk of bankruptcy or insolvency of the customer, and do not refer to trade disputes or returned merchandise. It should also be kept in mind that in a non-recourse transaction, the credit-worthiness of the customer may be scrutinized more closely before the factor agrees to buy the receivable.
Advantages of Factoring
Factoring accounts receivable can be beneficial in various different business situations. The following are some of its comparative advantages:
By factoring your accounts receivable you can have almost immediate access to cash.
Factoring can improve your cash flow by providing an ongoing source of cash. If you continue factoring, new invoices will replace those that are paid. As long as your business generates sales and accounts receivable, you can factor them and receive cash.
Factoring is a form of financing that does not necessarily depend on your business’s credit rating, since the factoring company is interested in the quality of your customer accounts. This can be particularly attractive to a new start-up business that cannot get traditional financing in the form of bank loans.
Only your receivables are used as collateral (if the receivables are factored under recourse terms; under nonrecourse terms there is basically no collateral), so you can use other assets, such as property and equipment as collateral for borrowing.
The relationship with the factoring company is not debtor and creditor, and there are generally no long term contracts involved, so factoring can be a flexible source of financing. But the opportunity is still there to establish a lasting relationship with the factoring company.
Factoring eliminates the need to spend time and effort in collection activities, since the factoring company takes over these responsibilities. By effectively outsourcing these functions, your business may be able to save on overhead administrative expenses.
With the cash you free up from receivables that may be 30, 60, or 90 days outstanding, you can take advantage of supplier discounts, or you can purchase the materials you need for a big job that may be awarded to you. If you had to wait for your customers to pay before you could purchase the materials you need, you may miss out on opportunities to expand your sales. Factoring can provide the cash needed by companies that are in periods of rapid growth.
By factoring your receivables and showing a stronger cash position on your balance sheet, you may find it easier to obtain traditional bank financing.
By using your own resources (your receivables) to finance your operations, you may be able to avoid taking on more debt or having to raise more equity, possibly giving up part of the ownership of your business.
Factoring can help protect your company’s credit rating by providing cash to meet payment due dates.
Disadvantages of Factoring
Factoring has a couple important drawbacks that must be taken into consideration:
Cost is probably the biggest disadvantage. Factoring can be an expensive form of financing. A discount rate of 1% to 5% on invoices with terms of 30 to 60 days results in a much higher annual rate than other traditional forms of financing.
You lose control over the collections process. This may have an effect on your relationships with your customers, depending on how the factoring company handles collections.