Accounts Receivable Factoring: Definition, Types of Arrangement and Example

In this article, we will cover the accounts receivable factoring. This will include the definition of factoring accounts receivables, aspect of accounts receivable factoring, types of factoring arrangements, as well as the benefit and limitation of accounts receivable factoring. Before jumping into detail, let’s go through basic overview.

As you know, accounts receivable reside under the current assets section of a balance sheet. The larger the assets the better it is for the business, No? Not in all cases. Accounts receivables are the cash inflows that a company expects to receive in the future, near or far. Many business arrangements demand for longer times to clear payments. There is no issue for any company if their accounts receivables remain in check and roll over quickly. Sometimes, business agreements or partner relations do not qualify the way a company plans. Delays in accounts receivables cause cash shortage and liquidity problems for the businesses. A company can outsource its collection of its accounts receivables to a specialized third party company which is called accounts receivables factoring.

What is Account Receivable Factoring?

Accounts receivables factoring can be defined as:

“The sales of accounts receivables or outstanding invoices to a factoring company or third-party against immediate cash”

The accounts receivables factoring is sometimes called accounts receivable financing.

It is an arrangement where the debt collection is assigned to an accounts receivables factor company or third party.

So what is a factoring company?

Typically, a firm that specializes in buying other firms’ accounts receivable is called an accounts receivables factoring company. In other word, accounts receivables factoring companies are also defined as a doer or transactor of a business for another. They specialize in trade debts and manage the debt owed to its client (a business customer) on client’s behalf. 

This kind of company operation commonly involves with taking the risk of bad debt in collection accounts receivable on behalf of its client.

Three Main Aspects of Accounts Receivable Factoring

There are three main aspects of factoring as follow:

  • Administration: This is responsible for by the factory company for the debt collection service.
  • Credit Protection: A business has access to credit protection by transferring the risk to the factoring company. This is known as non-recourse factoring whereby the factoring company takes all the risk of loss from the bad debts. With the non-recourse factoring, the factoring company, not the company, will decide what action to take against the non-payers.
  • Receiving Payment in Advance of Collecting the Debt: The business will receive the payment in advance from the factoring company. This is also called the factor finance because the factor provides cash in advance to the business for the outstanding debt.

Recourse vs Non Recourse Accounts Receivable Factoring

A recouse factoring or with recourse factoring refers to the factoring agreement between accounts receivables factoring companies and the business holding overdue accounts receivables and risk of uncollected remain under the business holding such accounts receivables. This means that the factoring company does not guarantee against bad debts. In a recourse factoring, the company or business holding the accounts receivables is responsible for recovering the cost if such receivables cannot be collected by the factoring company. Thus, the accounts receivable factoring companies do not bear the risk if the customer fail to pay the outstanding invoices. The recourse factoring is commonly used as the factoring company wants to avoid the risk of unpaid invoice. The responsibility for the uncollected receivables is given back to the business holding the receivables.

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In contrast, a non recourse factoring or without recourse factoring is a factoring agreement that the factoring company takes all the risk of loss from the bad debts. This is also called secured debt collateral. Typically, as mentioned in the above section, in the non recourse factoring, the factoring company will decide what action to take against the non-payers.

Generally, the fees for the non recourse factoring is higher than the recourse factoring. This is because the accounts receivables factoring companies bear all the risk of uncollected accounts receivables.

In the later section below, we will cover the different types of factoring arrangement.

Basically, the outsourcing of total outstanding invoices can be arranged in different ways. As these receivables involve cash, so are deemed highly liquid assets, which interest the companies providing factoring services. Receivables are earned income but delayed from the customers. Factoring or financing arrangements provide immediate cash relief for the business.

Accounts Receivable Factoring Arrangements

The business having outstanding amounts of invoices outsources the collection to another company, called factoring company. The arrangements or contracts made and the terms agreed are called factoring structure. Essentially the business can outsource the collection with the original source or without the without source. Most common factoring structures involve asset (invoices) sales and loans against assets. These arrangements are favorable to companies with growing trends that require immediate cash relief to fund their operations. Companies with shorter receivables days or good relations with customers may not find this arrangement attractive. Large companies can use this option as an alternative to bank loans if they opt for asset sales factoring option. The receivable loan option for all businesses may become an expensive option.

The Asset Sales Factoring

In this arrangement, the companies will sell all the outstanding invoicing balance to the factoring company. Typically this arrangement also works like a bank financing facility, the financier or the factoring company may offer cash up to 90% of the total invoice value. The company receives cash i.e. it replaces a liquid asset with another. As the terms dictate, the remaining outstanding invoice balance can either be written off or pursued as usual. The factoring company will be interested in confirmed sales and latest invoices. The factoring company may charge a higher fee or lend a lower percentage against the receivables as it now owns the risk of default.

Receivables Factoring With Loans

If the company wishes to keep the asset and still wants cash, it can opt for a loan agreement. The factoring company can provide financing up to 90% of the total invoicing or receivables amount. These loans are considered an unsecured loan, so the interest rate charged will be higher than a bank finance facility. The amount of loan financed will depend on the receivable number of days, total value, and the size of the company. Factoring companies will be offering better terms to large and stable companies with fresh invoices and a larger total value as collateral. Both these arrangements differ only with the ownership of the receivable asset. Unlike asset sale, in this arrangement, the company has to repay its loan and interest as agreed. The factoring company keeps the confirmed sales and invoices as collateral, failing to repay the loan results in seizure of the invoice amounts.

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Example of Accounts Receivables Factoring

In this section, we take a basic example of accounts receivable factoring. In this example, we will have two scenarios as below:

Example:

ABC Co makes an annual credit sales of US1 million. The normal credit term is usually 30 days. The credit administration of the company is usually at poor quality. This results in the average collection period of the company of 45 days with 0.5% of sales have been written off.

The company is looking for an accounts receivables factoring company to take over the debt administration and credit checking. The factoring company would charge an annual fee of 3% of credit sales. This would save the debt administration costs of US25,000 per year. The payment period would normally at 30 days.

The factoring company would also provide an advance of 80% of invoiced debts with an annual interest rate of 15% (3% higher than the current base rate). ABC Co would also be able to obtain an overdraft facility (OD) in order to finance its accounts receivable at annual rate of 3% over base rate.

Should the factoring service be accepted given the two scenarios above?

Assumption: we assume that the monthly revenue remains constants.

Solution:

First, let’s compute total costs if ABC Co enter into a factoring arrangement.

80% of credit sales financed by the factoring company is US$800,000. For consistent comparison, let’s assume that ABC Co would finance the remaining of 20% by bank overdraft. From the example above, we assume that the average credit period of the accounts receivable would be only 30 days.

The annual cost would be as follow:      

 US$
Factor’s finance 30/365 × US$800,000 × 15%9,863
Overdraft 30/365 × US$200,000 × 15% (12%* + 3%) 2,466
 12,329
Cost of factor’s services: 3% × US$1 million30,000
Total cost of factoring42,329

*12% is from the subtraction of the factoring advance rate of 15% against the excess of base rate which is 3%.

Now, let’s calculate the total cost if ABC Co finance by overdraft facility from bank.

Credit sales (Annual)US$1,000,000
Average credit period45 days

The annual cost is as follow:

 US$
45/365 × US$1,000,000 × 15% (12% + 3%)18,493
Bad debts 0.5% × US$1,000,0005,000
Administration costs25,000
Total costs48,493

Alternatively, we can compute the net difference between these two scenarios as follow:

 US$
Effect of reduction in collection period (45 – 30)/365 × US$1 million × 15%6,164
Extra interest cost of factor finance 30/365 × US$800,000 × (15% – 15%)
Cost of factor’s services 3% × US$1 million(30,000)
Saving in bad debts 0.5% × US$1 million5,000
Saving in company’s administrative costs25,000
Net benefit of using factoring service6,164

Thus, the cost of factoring accounts receivables is cheaper than using the overdraft facility from bank. If ABC Co select the accounts receivable factoring, the company would save US$6,164.

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The accounts receivable factoring journal entry is a little complicated. This involves both from the seller and factoring company perspective. Thus, we will cover in another separate article.

Considerations for Factoring Companies (The Financier)

The factoring arrangements cannot be made with one set of rules, as the finance seekers should be reviewed separately. The factoring company will be concerned with two key points, one with the collateral value of the assets and second the charges. Most factoring companies naturally look to avoid any defaulted or disputed receivables. Factoring service charges will depend on the risk factor and the company’s financial health similarly to a bank financing facility. However, often these loans or financing facilities are dubbed as unsecured loans, the interest rates and charges linked are higher than normal loans. Before making the arrangements, the financier company should look for the following key points:

  • Financial statements of the company i.e. the finance seeker
  • Financial forecasts and previous credit reports
  • Detailed segmentation of assets and liabilities
  • Finance seekers relations with the customers i.e. is there any dispute big enough reaching to the courts
  • The volume and days receivables of the outsourced invoices in total
  • If possible the financial health or creditworthiness of the customers

These considerations before the factoring arrangements can make the deal objective and clearer to understand for both parties.

Advantages of Factoring Accounts Receivable

Companies seeking cash can also opt for bank loans or other options, but that cannot solve the outstanding invoice balance issue. Factoring offers a two-in-one option for companies of getting the cash immediately and getting rid of the outstanding invoices. Some other advantages of factoring accounts receivable include:

  • Factoring provides immediate cash that increases liquidity for the company
  • The arrangement frees the company from rescheduling and chasing tasks. This reduce the cost of administrative staff who are responsible for collection while the company can access to the expertise of the debt management of a factor.
  • It helps to solve working capital issues as cash received through factoring can be used in operating expenses and accounts payables
  • The company keeps the choice of selling or outsourcing the accounts receivables
  • It can help strengthen business relations as the company receives cash and does not involve in collections directly
  • Businesses can maintain an optimum inventory level because they will have enough cash to pay for inventory they need
  • A business is able to maintain growth financed through sales rather than obtaining fund from external sources, for instance from bank

Limitations of Accounts Receivable Factoring

Although the accounts receivable factoring offers cash advantage and liquidity benefits, the arrangement also comes with some limitations for the company:

  • Credit customers need to pay directly to the factoring company which is likely to present a negative picture of the company’s attitude to the relationship of its customers.
  • By engaging the factoring company to collection on behalf, it may indicate that the company faces a rapid need of cash. This results in raising question about its financial stability.
  • The factoring companies often charge a high fee and higher interest rates on factoring arrangements
  • The company may have to write-off the remaining outstanding invoices not covered under a factoring arrangement
  • In the case of loan arrangement, the company has to repay the loan in full, failing to which may lead to seizure of collateral
  • Depending on the accounts receivable days and customer relations it may not be easy to make the factoring arrangements

Conclusion

Accounts receivable factoring can take form with invoice factoring, invoice discounting, and a structured finance. The most commonly used factoring arrangements are invoice factoring and loan arrangements. It’s a growing business for financier clubs, as they can charge higher fee and interest rates than banking facilities. For finance seeking companies the immediate benefits are receiving cash and increased liquidity.

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