Accounts Receivable Financing vs Factoring - What are the differences?
Accounts receivable vs factoring are often used synonymously. If there is a clear difference, in factoring, you have actually sold the receivable, so technically it is not a loan but a sale of a financial asset.
In accounts receivable financing, (if it isn't just re-named factoring) the receivable is collateral for the loan. Typically in financing, the collateral is just the base for the loan, and there is still recourse beyond the collateral. In Factoring it is possible for the receivable to be the only collateral, so it can be a non-recourse (or limited recourse) financial transaction.
Apart from the nomenclature (and there are so many flavors of this it is hard to really pin down); if you sell the receivable, you remove it from AR, you get the cash and you are done. If you obtain financing, you keep the receivable because it is still your problem, you book the cash and off-set it with a credit to bank financing liabilities.
Factoring is usually more expensive. That's due to the factor having the receivable as the only source of payment. This is perceived as riskier and more operationally intensive, thus it's priced higher. AR loans tend to be less expensive because, as noted earlier,the lender has the AR collateral and also a claim against the borrower.
Operationally, factors review/purchase individual receivables. AR lenders typically advance against a revolving pool of receivables under a borrowing base arrangement .
One more distinction is the difference in how the two are managed. An accounts receivable line, called a Revolver, uses a borrowing base, which is derived by looking at your A/R aging and removing all amounts that are over 90 days old, and then advancing to you 80% of what's left. Every month you submit a Borrowing Base Certificate which includes that calculation to show that you still have adequate A/R to support the line. You don't have to pay off the line monthly, you can roll it forward. Ergo the name "Revolver".
The factoring line, as been said in the prior comments, is essentially a sale of a particular A/R. You provide your factoring company your invoices and they decide which ones they will finance. Typically they will pay you 80% of the value of the invoice. So you can figure of course that it's costing you 20% of the value of the invoice, which is expensive, but useful for some companies at an inflection point before they qualify for a Revolver, which is less expensive.
This is a highly simplified breakdown, but the essential mechanics behind both. Happy to provide more detail if necessary.
Rob, quick correction - the factoring transaction has three parts; the advance (usually around 80% of the face value of the invoice,) the reserve ( the remaining percentage being held back until the account debtor submits the invoice payment,) and the discount fee (the actual cost of funds which is typically 2 -3%, not 20%.)
From a practical standpoint, invoice factoring is usually for companies that are either challenged or still emerging. Asset Based Lenders who offer the revolvers mentioned above like to see a minimum of $1M in new invoicing each month which is reflective of a more mature company. So factoring clients graduate up to asset based financing.
While factoring is normally priced by the discount fee per invoice, revolvers are priced on a sliding Prime Plus interest rate while funds are in use. Revolvers also include an Origination Fee, an ongoing line charge and could include a minimum usage fee. A borrower will want to quantify all these different charges to get a true "all in" cost of funds.
My view of using Factoring and/or ABL: Both forms of financing carry higher than normal interest rates to maximum interest rates allowed by law.
That makes it difficult or extremely difficult to grow your company and remove yourself from the cycle of factoring/ABL. Your interest payments may just cripple your profit margin.
Here's my suggestion that mitigates the cycle:
Take down the least amount of credit you need to run your company. Let's say you can get $1M. But you only need $600K. The difference on the spread, less the cost of money you borrow will enable you to buy yourself out of the lender in time (figuring a growing business).
If you are lucky you will be able to obtain a traditional bank loan and convert your debt as well as lower (dramatically) the cost of money.
Factoring and accounts receivable are two forms of financing based on “receivables,” offering business owners and entrepreneurs an alternative to traditional bank loans. If you need cash now, you should consider these financing options. The difference between them is that Factoring buys your individual Invoices whilst Accounts Receivable Financing is effectively a Lend against your revolving Ledger.