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Account Receivable Financing - Frequently Asked Questions
- What is an Account Receivable (A/R)?
- Should my company extend credit to customers?
- Is there any risk if my company extends out credit?
- What is Factoring? Also known as Account Receivable Financing (A/R Financing)
- Who does A/R financing?
- How are factoring fees determined?
- Is there a difference between a Bank and a Factor?
- Is Factoring right for me?
- How does Factoring Work?
- I heard if I use a factor that my customers might get the idea that I am in financial trouble, Is that true?
- Will a factor treat my customer with respect when collecting the funds?
- Is there a limit to the amount that I can factor?
- Is there a limit to the amount that I can sell to one customer?
- Do I need to factor all my invoices?
1. What is an Account Receivable (A/R)?
A/R is money that is owed to your business for services rendered or goods sold and billed to your client on term. For example, when you sell a product to a customer and bill them an invoice for 30 days you are extending credit to the account debtor. That invoice would be classified as an account receivable.
2. Should my company extend credit to customers?
By allowing the account debtor to pay an outstanding invoice in 30 days, you are in essence extending credit to your buyer. Extending credit to a customer can be a great advantage to any business. When credit is issued to a customer it will increase the buying power of that customer by allowing them time to repay its debt. The more products the customer can afford to buy the more they will sell, produce, or meet their own contract deadlines. By extending that credit, the seller is indirectly increasing their sales by encouraging more ambitious business by the account debtor.
3. Is there any risk if my company extends credit?
Yes, Companies need to be very careful to whom they extend credit to, due in fact that they might not get paid for the services rendered. It is possible for a company to buy services or products and after receiving the product or service, decide not to pay the seller. With the right measures a company can reduce that risk. Key words to keep in mind are REDUCE YOUR RISK. In business a Seller can only reduce their risk, not get rid of it. Bad payers come in all shapes, colors, sizes, and numbers. A company with $40,000,000 in assets,1,000 employees, 400 locations, or $100,000,000 annual gross sales is no indication that the company is guaranteed to pay you.
4. What is Factoring? Also known as Account Receivable Financing (A/R Financing)
Factoring is the process whereby a company sells its accounts receivable to a factor at a discount and receives cash. Once determined as an account receivable, your company has the right to sell their invoice for cash. The act of selling and buying receivables is A/R financing. For example, a company has $10,000 of sales invoices to factor. The factor advances to the company a certain percentage of the invoice upfront. For this example, let's use 75% so that at the time of purchase $7,500 minus $200 (2% for factoring fee) $7300 is advanced to the Company (if you are quoted advances of 90% or greater, make sure that you read the fine print in your contract – there might be a "catch"). This upfront payment is not a loan, but an advance on the purchase of accounts receivable. The factor then collects the invoices and sends the balance of $2,500 when the invoices are paid in full. Fees are typically based on how long it takes to collect each invoice and the size of the invoice.
5. Who does A/R financing?
There are two types of factors; ‘Recourse factoring’ and ‘Traditional factoring’.
- Recourse factoring is when the client of the factor takes the risk on the sale of the invoice. This means that if the invoice is not paid by the invoice due date or by 90 days of the invoice date, the factor gives the invoice back to you (charge back). At that point, the client is responsible to pay back the factor the money that was advanced against the invoice that was charged back. The factoring fees are typically lower than traditional factoring, since the client is taking all the credit risk.
- Traditional factoring is when the factor takes the entire risk of the invoice. This means that no matter how long it takes, the factor is responsible for collecting the money for the invoice directly from the account debtor. Even if the customer goes bankrupt or fails in anyway to ever pay the invoice, the factor is the one who will be stuck with the loss. IF THE FACTOR DOES NOT RECOVER FROM THE ACCOUNT DEBTOR, YOU OWE NOTHING. The factor is not responsible if the invoice is under dispute by the customer for any reason (defective or incorrect goods). Keep in mind this method costs more and you might have a factoring company harassing account debtor for money (since they are taking the risk).
6. How are factoring fees determined?
Factoring fees are based on the size of the invoice, the length of the term as well as the credit risk that the factor is taking. The more invoices that need to be verified the more fees the factor needs to charge. Factoring fees are negotiated between the factor and the client.
7. Is there a difference between a Bank and a Factor?
If a bank approves your application it can take them up to 2 months to fund your account. A factor can fund your account within a few days after acceptance. A bank generally considers people or companies with bad credit to be un-bankable. A factor, on the other hand, relies on the creditworthiness the account debtor. Banks usually turn customers away if the company had one bad fiscal year due to seasonal down trends. Factors look at more than one component to analyze the client. Fees are also a major difference between a bank and a factor. A bank charges a flat interest rate per year, while a factor charges a fee to purchase the invoice. Usually the interest rate will be cheaper than the fee that the factor will charge. However keep in mind that a bank will hold more collateral to secure their funds, and they will not give any of the services that a factor will give to you such as A/R analysis, credit and risk analyses, portfolio management, and tax lien monitoring and if you take on a bank loan it is going to effect your balance sheet. Over all a factor provides more services than a bank will.
8. Is Factoring right for me?
I recommend that any time you are going to make an important financial decision that you speak with your accountant. Factoring can be a very useful tool for any company. It can be a short-term solution to a big problem such as shortage of cash flow, which can be cause from extending out a too much credit, slow paying customers or growing too fast? Banks need to comply with strict governmental regulations to issue a loan where as a factoring regulations are more lenient. Some of those regulations are 3 years of positive cash flow. This can be hard for a company that had one bad season or very strong growth. One thing to take into consideration that factoring should be a short term cash solution. Remember, the longer the account debtor takes to pay an invoice the more fees you are going to accrue, because factors fees are based on the length of time an invoice goes before it is paid in full. The more fees you pay the more it will affect your bottom line.
9. How does Factoring Work?
- Submitting an application and preparing some documentation that the factor will require (such as financial statement, 941 tax payment, Current A/R and A/P, ect.). Once the application has been submitted with all the corresponding paperwork (documentation that are missing from the application might cause delays in funding.) and the factoring contract has been executed.
- The factor will then notify the account debtor that the invoice has been assigned and is payable to the factoring company.
- Once the account debtor has been notified, the client will submit their invoices to the factor.
- The factor will verify that the invoices have been received and accepted by the account debtor. Usually the verification
process will take 2 to 3 days. As soon as the Invoices have been verified the money will be wired to the clients’ bank account. Depending on the factor you will get any where from 70 to 95% of the invoice amount minus the factoring fees.
- The account debtor will remit payment to the factoring company.
- Once the invoice has been paid in full you will then receive the rebate.
10. I heard if I use a factor that my customers might get the idea that I am in financial trouble. Is that true?
Factoring has been around for centuries. Certain industries utilize factors versus banks. In those industries it is a standard business practice to use a factor because of the nature of the business. It should not make any difference to the account debtor how you get financed as long as they are getting their merchandise or services from you. Unfortunately, many people do not understand what factoring is and for that reason they might make inaccurate assumptions. If a factor is used correctly they can be a great tool to aid in the success of a business to finance expansion, increase cash flow or meet a particular projects demand.
11. Will a factor treat my customer with respect when collecting the funds?
It is very important to choose the right factor. Most factors understand the importance and the affects of customer service on a business. The main objective for a factor is to meet the needs of the client, which ultimately is collecting the funds without jeopardizing any relationship between the client and the account debtor. In order to do this they will be very respectable to the account debtor whom they are collecting the funds from.
12. Is there a limit to the amount that I can factor?
No. Factors are not banks and do not give out loans. A factor buys invoices; therefore the limit to the amount that can be factored depends on the amount that has been invoiced.
13. Is there a limit to the amount that I can sell to one customer?
Yes, it is to the discretion of the factor to decide what the account debtors’ credit limit is going to be. This credit limit is for the protection of your company as well as the factor. Remember that in the case of recourse factoring the client is responsible for the invoices and the payment. Concentration issues are one of the main reasons that companies fail. By setting credit limits the company will be able to control its cash flow and reduce its risk from its customer.
14. Do I need to factor all my invoices?
No. It is up to you to choose which customers and invoices that you want to factor.
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