At one time or another, most businesses will extend credit in some fashion to at least some of their customers. Credit allows the customers to purchase a product or service and make full payment at a point in time after the transaction has occurred.
By extending credit, the business expands the payment options available to its customers. This helps build a foundation of trust, and it expands the range of potential customers who are available to engage with the business because not all customers prefer or are able to pay in cash.
A transaction bought on credit is recorded in the business journal as an account receivable. This accounting term refers to a transaction for which payment is expected at a future time.
For some businesses, accounts receivable may pose a challenge because of the need for cash in the short term before payment is expected. In these situations, a business may engage in a form of short-term financing known as accounts receivable factoring.
In this type of financing transaction, a business sells accounts receivable invoices to a third party or factor company. That company pays the business a portion of the accounts receivable amount so that it can have cash right away, and the two parties fully reconcile the transaction at a later time after the customer makes full payment on the original invoice.
Accounts receivable factoring typically contains one of the following three characteristics:
Recourse or Non-Recourse Factoring: refers to the ability of the factoring company to recoup the full cost of the invoice from the business should the customer fail to pay. When the factoring company has that ability, it has "recourse" to collect payment from the business if the customer defaults. In this scenario, the business that received the factored payment must absorb the loss. In non-recourse factoring, the lender cannot collect and will have to incur the loss, instead of the business, if the customer does not pay.
Notification or Non-Notification Factoring: describes the presence or lack of communication in the form of instructions between the factoring company and the original customer. In notification factoring, the company issues new payment instructions to the customer when it has engaged in a factoring transaction with the business. In non-notification factoring, the financing company will not initiate any new communications or instructions, and the customer will not know that the business has entered into a factoring transaction.
Regular vs. Spot Factoring: reflects on the scope of the relationship between the factoring company and the business. Specifically, it describes whether they have an ongoing relationship that extends beyond one transaction or if the factoring is done on a one-time basis. Regular factoring describes an open-ended process, much like revolving credit with a set limit, which the business can draw upon and repay as invoices are paid off and new invoices are generated. In spot factoring, the business receives payment from a company in a single transaction for one, specific invoice only.
Because accounts receivable factoring is a type of financing, certain costs are associated with it.
The formula for calculating accounts receivable involves several calculations.
First, the factoring company will calculate the advance rate. This is the percentage of the total invoice value that the factoring company is willing to pay to the business and reflects the value of the invoices that are to be factored, including how old they are and the customer's creditworthiness. Usually, the advance rate will fall between 80-90% of the total value of the invoice.
Second, the factoring company will apply fees. These include a discount fee and a service fee. The discount fee represents the cost of financing and will be calculated as a percentage of the total amount that is factored in, like an interest rate. It will typically fall in the range of one to five percent of the advanced amount. Lenders will also charge a service fee, which is an additional charge that covers administrative services like invoicing and collections. It may be either a flat fee or a percentage, which is usually much smaller than the discount rate, maybe even less than one percent.
The calculation formula can be represented as:
Accounts Receivable Factoring Amount = Total Invoice Value x Advance Rate – Factoring Fee
Like all transactions, accounts receivable factoring will need to be recorded in the business's accounting ledger.
How it is recorded will depend on the type of factoring transaction that the business has engaged in.
If a business enters into recourse factoring, its journal entries must account for the liability of the invoice, or the possibility that the business will have to absorb the loss if the customer does not pay.
In these situations, business accountants will record several entries:
A credit in accounts receivable for the invoice that has been sold to the factoring company.
A credit in recourse liability (after the potential for bad debt and loss have been estimated).
A debit in the cash account for the cash payment that has been received.
A debit loss for the factoring fee and the estimated bad debt.
A debit-due for the total amount that the factoring company will retain when the transaction is complete.
Non-recourse factoring does not create the same level of liability for the business and its journal entries will reflect this difference.
Entries will include:
A credit for the amount sold in accounts receivable.
A debit in the cash account for the cash that has been received.
A debit loss for the factoring fee that has been paid.
A debit-due for the amount the factoring company will retain
Businesses use accounts receivable factoring for several reasons. Primarily, they employ factoring to receive cash immediately rather than wait for an invoice to be paid.
Businesses that experience inconsistent or irregular payments from customers as a result of a unique market or clientele, or businesses that need cash upfront, employ factoring to fill this need.
Businesses that are experiencing issues with the credit that is extended to their customers may also employ factoring to provide sufficient cash while the credit issues are addressed.
Factoring has many benefits for the businesses that rely on it. Cash received from factoring provides liquidity to a business and may improve cash flow. Engaging with a factoring company relieves the business of the stresses of accounts receivable by outsourcing that function to a third party, and in the case of recourse factoring, it outsources the risk of default, too.
Factoring also provides companies with additional and sometimes more flexible financing options besides conventional lending choices, such as credit lines and small business loans. Finally, factoring gives a business the ability to offer customers more flexible payment options, depending on the options that it receives from the factoring company.
The cost of factoring is a reflection of several details related to the invoice, including the industry, the credit-worthiness of customers, the time it takes customers to pay invoices, and the size and volume of the invoices.
Generally, factoring can cost a business anywhere from one to five percent of the value of the invoices involved. This figure represents the combined total of discount and service fees paid to the factoring company. Some companies also offer volume discounts for businesses that factor a large volume of their accounts receivable.
To see how the costs of factoring are calculated, consider an example in which a business has an unpaid invoice of $100,000.
The factoring company it applies to for a cash payment offers an advance rate of 80 percent combined with a discount fee of two percent and a flat service fee of $500.
In this example, the first step of the factoring formula would be calculated to determine how much will be loaned to the business:
Advance amount = (Invoice X .80) = $100,000 X .8 = $80,000
When the invoice is ultimately paid by the customer, the factoring company will calculate the remaining steps in the formula to determine what it is owed by the business.
It will repay itself for the initial payment of $80,000, and the business will receive the remaining balance with adjustments. The remaining balance will be calculated by subtracting the advance amount from the original invoice total:
Remaining balance = $100,000 - $80,000 = $20,000
Adjustments will be calculated by subtracting the discount and service fees from the remaining balance:
Adjustments = $20,000 - (.02 + $500) = $20,000 - ($1600 +$500) = $17900
The amount that the business receives equals the advance amount plus the adjusted remaining balance, which will equal a sum that is slightly less than the total value of the original invoice:
$80,000 + $17900 = $97,900 < $100,000
As compensation for its lending services, the factoring company will have earned the total of its discount and service fees, or $2100.
Accounts receivable factoring may be confused with another type of transaction that involves the value of unpaid invoices. Accounts receivable financing describes a type of loan that a business receives by using the unpaid invoice as collateral.
The business repays the loan with the proceeds it receives as invoices are paid. Like factoring, it is a way for a business to generate cash that can be applied to other facets of the business.
.Unlike factoring, it is strictly a loan and the lending company has no involvement in the collection of payment from customers.
BlackLine Cash Application can help manage accounts receivable factoring and other aspects of the cash conversion cycle by leveraging AR automation to eliminate manual processes, gain visibility and control, and achieve the most efficient end-to-end invoice-to-cash process.
Schedule a demo with us to find out how BlackLine’s cash application software can help streamline your business’ invoice-to-cash process!