Understanding this important distinction will help a business select the right financing terms when factoring invoices and accounts receivable.

Understanding Recourse Factoring

When a factoring company advances funds to a business client on their accounts receivable they expect to receive payment from the client’s customer or account debtor.  However, if the customer does not pay the invoice then the factor can demand payment from the client with recourse factoring.

Since the factor does not assume the credit risk with recourse factoring it is generally less expensive than non-recourse factoring. A factor may also demand less control and have fewer requirements pertaining to systems and customers.

Of course the flip side is the business receiving the advance is ultimately at peril for loss from bad debt with recourse factoring.  If their customers don’t pay on the invoice they must repay the advance along with any fees to the factor.  A factoring company will generally charge back any delinquent invoices to the business client after 90 days, depending on the terms of the agreement.

Understanding Non-Recourse Factoring

The factoring company takes on the risk of bad debt with non-recourse factoring.  This means the factor goes after the customer or account debtor for payment on delinquent invoices.

The factoring company will generally check credit on account debtors and handle the collection and bookkeeping functions.  They tend to underwrite the creditworthiness of the client’s customers more than the client itself.

While the client may not have to refund the advance to the factor if a customer does not pay for credit reasons, they are still liable for any payment disputes involving the product or service itself.

Popularity Contest

The use of Non-recourse factoring is by far the most popular type of factoring arrangement.  Overall non-recourse factoring accounts for about 85% of transactions with full recourse factoring making up about 10%.  The final 5% is a blend of the two with partial recourse to the client. (Source: Commercial Finance Association 2007 Factoring Survey Results).

Rather than a loan, factoring is primarily structured as an outright purchase of accounts receivable on a non-recourse basis.  This enables factors to say yes to cash advances on creditworthy invoices when traditional banks say no to business loans.

Cash is always in demand so there’s no shortage of companies that can benefit from the business funding factoring provides.  The greater challenge is finding a business that is likely to receive funding from a factor. Ask these 4 questions to identify a good candidate for factoring accounts receivable:

1. Who is the Customer?

A business that sells to the government or another business will make the strongest factoring client.  Most investors do not factor invoices that are paid by an individual consumer.

If marketing to companies as a factoring broker that means to generally avoid retail stores and any other direct to consumer type business.  Instead target a company with business-to-business or business-to-government invoices to satisfy the preference of factoring companies.

2. Does the Customer Qualify?

A factoring company looks for payment from the customer that owes money on the invoice.  This debtor must be credit-worthy to qualify for an advance on the invoice.  As part of the screening process the factor will review aging reports and a credit history on the debtor.

Unfortunately, many businesses are not sure if their customers are good credit risks until they don’t receive payment and it’s too late.  Using the factor to pre-qualify customers before extending payment terms can be a benefit to the business in addition to the immediate cash advance (more details at How to Be Sure Your Business is Paid).

3. Does the Invoice Qualify?

In order to advance funds on accounts receivable the goods or services must have been delivered.  A factoring company won’t discount an invoice if there is still work to be performed or product to be delivered.

The invoice also must be free of any offsets.  An offset is when a customer can claim a credit against the money they owe for some reason.

4. Will the Business Prospect Benefit?

If a business is receiving payment immediately or within 10-15 days they may not see an advantage to factoring. However a company that is waiting 30 or more days is more likely to need and recognize the benefit of receiving an immediate cash advance.

Startup companies, fast growing industries, and those not yet considered “bankable” by business lenders often benefit from factoring.   They have cash needs for bills, payroll, overhead, and expansion that are not being met through traditional business loans or lines of credit.

Whether considering factoring for your own business or marketing to businesses as a factoring broker, the answers to these questions will help determine if factoring account receivables will be a viable solution.