Selling Accounts Receivable to a Factor - the How and Why

How Factoring of Accounts Receivable Works

How Accounts Receivable Factoring Works
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Businesses need cash to stay afloat, and sometimes cash just doesn't come in fast enough. In these situations, you might want to consider a quick way to get some cash by using accounts receivable financing (also known as factoring).

What is Factoring?

Factoring means that someone will buy your accounts receivable (often shortened to "receivables") and they will do the collecting. You can sell all or some of your receivables to the factor or you can sell individual invoices directly. According to Investopedia, the factor will typically give you 70 to 90 percent of the value of outstanding invoices. They may also charge a fee for each invoice or each account.

Factoring is a $3 trillion business, and it has been around for a long time. Factoring companies are legitimate businesses. They make their money by knowing the value of receivables and being good at collecting on them.

The buyer obviously cannot give you full value on your receivables, because they don't know whether they will be able to collect and because it will take a good deal of time and money for them to check credit on all your customers and to run the collections process.

What Can I Expect to Be Paid? How Long Does It Take to Get My Money? 

Factoring companies pay based on (1) the length of time the receivables have been outstanding, (2), the number of receivables, and (3) the credit ratings of your customers.

The factor will review your receivables and give you an initial amount within a few days. Then they will charge a fee for the actual collections of 2% to 6%, depending on how difficult the receivables are to collect. With the initial discount on the purchase of your receivables and the fees, you will probably get no more than 40 percent of your receivables. That's just an estimate; your costs might be different.

An Alternative to Selling A/R to a Factor

If you need cash and you have many receivables, another possibility might be a working capital loan or a business credit line. The bank may be willing to take your receivables as collateral. The interest rate on this type of loan should be lower than the cost of selling to a factor.

What About My Customers? 

The factoring company wants to treat your customers well, for three reasons:

  1. The factoring company wants to get the payment.
  2. The factoring company doesn't want to destroy your relationship with your customers because they want your company to continue to rely on them in the future.
  3. The factoring company must adhere to the same collections laws as other companies. 

Before you Sell Receivables to a Factor:

Use your business financial software service or an accounting firm to prepare an accounts receivable aging report, so you can see who owes you and how long that account has been unpaid.

Can I Use a Factor on a Continuing Basis?

Many factoring companies become de facto outsourcing for accounts receivable. That is, you could continue to turn your receivables over to the factor so you don't have to spend the time and money to collect. If you have individual customers or clients, you might want to collect personally, but if your customers are other businesses, you might decide that factoring can save you money and hassle.

How Do I Select a Factor? 

Do an Internet search to find a list of factors who work in your state. Then select several to interview. Some key points to look for when selecting a factor:

  • What experience have they had with factoring? How long have they been in the business?
  • Who will actually be doing the contacts with my customers? What is this person's demeanor? Is he/she friendly? Courteous? Be sure that the factor will not destroy your goodwill with your customers.
  • How does the factor contact customers? If possible, review the phone scripts and letters they use, to gauge their professionalism and courtesy.
  • Does the factor refer accounts to collections? What criteria do they use for doing this? Do they notify you they are turning over an account to collections? If you have a continuing customer who doesn't pay bills, you need to know this. The factoring company should be in communication with you about their interactions with your customers.

    How to Find a Factoring Company

    The International Factoring Association has a member directory you can search. Try searching by industry or location.