Factoring Versus A/R Financing: What’s the Difference?

By Tom Klausen

In today’s tight credit environment, more and more businesses are having to turn to alternative and non-bank financing options to access the capital they need to keep the gears of their business running smoothly.

There are a number of different tools available to owners of cash-strapped businesses in search of financing, but two of the main ones are factoring and accounts receivable (A/R) financing. Sometimes, business owners lump these two options together in their minds, but in reality, there are a few slight differences that result in these being different financing products.

Factoring vs. A/R Financing: A Comparison: Factoring is the outright purchase of a business’ outstanding accounts receivable by a commercial finance company, or “factor.” Typically, the factor will advance the business between 70 and 90 percent of the value of the receivable at the time of purchase; the balance, less the factoring fee, is released when the invoice is collected. The factoring fee—which is based on the total face value of the invoice, not the percentage advanced—typically ranges from 1.5-5.5 percent, depending on such factors as the collection risk and how many days the funds are in use.

Under a factoring contract, the business can usually pick and choose which invoices to sell to the factor—it’s not usually an all-or-nothing scenario. Once it purchases an invoice, the factor manages the receivable until it is paid. The factor will essentially become the business’ defacto credit manager and A/R department, performing credit checks, analyzing credit reports, and mailing and documenting invoices and payments.

A/R financing, meanwhile, is more like a traditional bank loan, but with some key differences. While bank loans may be secured by different kinds of collateral including plant and equipment, real estate and/or the personal assets of the business owner, A/R financing is backed strictly by a pledge of the business’ assets associated with the accounts receivable to the finance company.

Under an A/R financing arrangement, a borrowing base of 70 to 90 percent of the qualified receivables is established at each draw against which the business can borrow money. A collateral management fee (typically 1-2 percent) is charged against the outstanding amount and when money is advanced, interest is assessed only on the amount of money actually borrowed. Typically, in order to count toward the borrowing base, an invoice must be less than 90 days old and the underlying business must be deemed creditworthy by the finance company. Other conditions may also apply.

Features and Benefits: As you can see, comparing factoring and A/R financing is kind of tricky. One is actually a loan, while the other is the sale of an asset (invoices or receivables) to a third party. However, they act very similarly. Here are the main features of each to consider before you decide which one is the best fit for your company:

Factoring:      

• Offers more flexibility than A/R financing because businesses can pick and choose which invoices to sell to the factor.

• Is fairly easy to qualify for. Ideal for newer and financially challenged companies.

• Simple fee structure helps the company track total costs on an invoice-by-invoice basis.

A/R financing: 

• Is usually less expensive than factoring.

• Tends to be easier to transition from A/R financing to a traditional bank line of credit when the company becomes bankable again.

• Offers less flexibility than factoring because the business must submit all of its accounts receivable to the finance company as collateral.

• Businesses will typically need a minimum of $75,000 a month in sales to qualify for A/R financing, so it may not be available for very small companies.

Transitional Sources of Financing: Both factoring and A/R financing are usually considered to be transitional sources of financing that can carry a business through a time when it does not qualify for traditional bank financing.

After a period typically ranging from 12-24 months, companies are often able to repair their financial statements and become bankable once again. In some industries, however, companies continue to factor their invoices indefinitely—trucking is an example of an industry that relies heavily on factoring to keep its cash flowing.

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