When a business needs cash but doesn’t want to borrow money they often turn to Accounts Receivable Funding, also known as Factoring. Rather than a bank loan, the business sells the right to receive payment on outstanding invoices to an investor or factoring company.
When the business delivers goods or services to a customer an invoice is created. The average customer or debtor may wait 20, 30, or even more days, before paying the invoice. Rather than wait for payment, the business can receive an immediate advance on the face amount of the invoice from the factoring company.
The factoring company issues the advance to the business and keeps back a portion in reserve. When the invoice is paid the reserve is released to the business, less the factoring fee. There is no interest or loan fee charged as the process involves the assignment of an invoice rather than the creation of debt.
Here is an example of how accounts receivable funding works:
- Invoice Amount Customer owes Business = $1,000
- Advance Rate Paid to Business (Assumes 80%) $800
- Reserve Held By Factor (Assumes 20%) $200
Invoice paid in 30 days
- Fee Deducted from Reserve (Assumes 2.5%) <$25>
- Balance of Reserve Paid to Business $175
- Total Amount Received by Business $975
The amount of the advance, reserve, and factoring fee can vary by industry, customer strength, and how long it takes the customer to pay the invoice.
Some factoring companies might also charge a small one-time set up fee to the business upon acceptance (averaging $350). While the assumptions may vary from the example, they will be clearly spelled out upfront in the proposal and agreement between the business and factoring company.