What Is Accounts Receivable Factoring: How Factoring Receivables Works

In this article: 

• What is Factoring Receivables?
• How Factoring Receivables Works
• The Standard Factoring Agreement Process
• What is a Factoring Agreement?
• Invoice Factoring Fees: How to Read the Fine Print in Your Factoring Agreement
• How Much Does Factoring Receivables Cost?
• Examples of Accounts Receivable Factoring
• Common Use of Factoring Receivables
• Why Do Companies Factor Receivables / Benefits of Using Accounts Receivable Factoring
• Factoring Versus a Traditional Bank Loan or Line of Credit
• Do I Qualify for Factoring?
• Top 5 Tips for Factoring Receivables from the Experts 

What is Factoring Receivables?

It takes money to make money. That classic adage can be especially true for small business owners looking to grow. For all the work that goes into finally scoring that big new contract, finding the money for the staffing and supplies to support the expansion of work can be challenging – especially when it will be at least a month before your new client pays their first invoice.  Yes, the money is coming, but you need to pay your people now. 

When in a pinch, many owners look to their banker to help out. But getting a bank loan to fill in the gaps between services delivered and invoices paid isn’t easy. Frankly, it’s not typically what they do. And for those that do provide accounts receivable financing, it’s typically pretty expensive. 

Another option is to use a credit card. But if you don’t have the money to pay off that balance, the fees and interest make it a poor option – and an option that could make your business poor. Plus, it could damage your credit score for funding future growth.

Invoice Factoring (sometimes called “accounts receivable financing”) is an alternative. It is not a loan. It does not impact your credit. Instead, invoice factoring is a financial service that allows business owners to leverage tomorrow’s income for the money you need today. 

Invoice factoring is when a business sells their invoices (also called accounts receivable) that are due, and then are payable to a third-party firm. This third-party firm is called the “factor,” and they pay businesses quick cash or invoices with future due dates in exchange for a fee.

In other words, invoice factoring allows businesses to receive an advance on the amount they’re owed from their customers. This allows business to meet their immediate financial obligations, offering a flexible, low-risk solution for businesses with cash-flow challenges. 

Factoring is not a new concept.

For hundreds of years, business owners have used factoring to finance their growth and expansion – and even exploration. Back in the 1400s, Christopher Columbus was turned down for “traditional” funding for his expedition. Instead, a consortium of bankers stepped in to advance him the money he needed against the riches he was determined to find. As a result of early factoring, he was able to support the crews and materials for the Nina, Pinta and Santa Maria as they embarked on their famous voyage to the edge of the known world.

How Factoring Receivables Works

The factoring company (such as MP Star Financial) buys your customer invoices from you, and then quickly provides you with funds – usually the same business day. A factored invoice is not a loan, so your company does not take on more debt. 
Here’s an overview of how factoring receivables works:

• Step 1: You sell your services or products to your customer, as usual.
• Step 2: You invoice the customer as soon as the services are delivered.
• Step 3: You present the invoice to MP Star. The invoice is “purchased,” and you are immediately provided an advance payment, usually 80% or more of the invoice amount. The remainder – about 20% – is held in reserve.
• Step 4: Your customer pays their invoice (with your name on it) to MP Star. After payment is received, the reserve amount minus transaction fees is sent to your company.

The key here is that you get the bulk of the money owed to you almost immediately, to make sure you can cover the expenses that come with running your company and also have the capital you need to grow.

There is some preliminary paperwork that MP Star Financial will ask you to complete, and credit checks will be run on the customers whose receivables you would like to factor, but all this can be completed in just a few business days.

In terms of your customer relationships, probably the only change they will notice is a new address for mailing payments.

If you have questions about the terms used, you can refer to Factoring Terminology. Actual rates will vary based upon the nature of the advance size and the customers. For actual rates please submit a Request for a Quote.

The Standard Factoring Agreement Process

Here is a more detailed, step-by-step look at the process of how invoice factoring works based on a standard factoring agreement and process. 

1. Factor will complete its due diligence on the client and the customers.
2. Factor and the client will enter into a “Factoring and Security Agreement,” as well as some additional documentation.
3. Factor will notify the customers of the change of address for remittance of payments on behalf of the client.
4. The client will submit an advance request for, let’s say $10,000 to MP Star Financial along with the invoices, the supporting documentation and assignment.
5. The factor will verify the advance to ensure that the invoices are complete and that the accounts receivable are due and payable.
6. Factor will multiply the advance request of $10,000 times the advance rate of 80% (or $8,000) and subtract the initial factoring fee of $250 for a total funding to the client of $7,750.
7. The invoices are then mailed to the customers.
8. The customer sends payment to the lockbox within 30 days.
9. The factor receives the payment and will deduct from it the payment the amount advanced and the initial fee. The factor would then give the client the balance left over when the reserve settlement is released. 

In this example, using an advance rate of 80% and an initial fee of $250 (our “One Fee Factor”) for an initial fee period of thirty days, the factor will advance 80% of the $10,000 advance request (or $8,000) less the initial fee of $250 for a total advance of $7,750 to the client. The other 20% would be held in escrow and paid out to the client once invoice is paid, minus any fees.

To the extent that some invoices are not paid in thirty days, additional late fees are charged on only the invoices unpaid for each late fee period that an invoice is outstanding. Those fees are outlined in your factoring agreement. 

What is a Factoring Agreement?

A factoring agreement is a contract between a factoring services company (called the “factor”) and a business (called the “client”). A standard factoring agreement details the sale or “purchase” of the business’ accounts receivables or invoices in return for short-term capital to help fund the client’s business.

In many cases, factoring agreements are revolving. Like a credit card, once the amount is paid down, you can use more money again as tied against receivables that quality for factoring. 

Invoice Factoring Fees: How to Read the Fine Print in Your Factoring Agreement

The challenge with many factoring agreements is the fine print. Many include high interest rates, fees, late fees, and other hidden tricks that turn what appears to be a simple financial service into a very expensive one. But not all factors are alike. MP Star Financial offers One Fee Factoring®, and a no-hidden-fees guarantee. We have a long history of maintaining long-term relationships with our clients, supporting their growth and providing financial solutions with a high level of transactional transparency and service.

To help you better understand, here is an actual sample of a factoring agreement proposal that highlights some of the hidden fees to watch out for: “A Lesson In Hidden Fees.”

As part of MP Star’s “One Fee Factor” approach, we take a different approach than many of the other companies in our space.

• No term obligations
• No cancellation fees
• No minimums
• No new client fees
• No ACH fees

How Much Does Factoring Receivables Cost?

Most business owners and operators new to factoring are surprised at how reasonable the fees associated with MP Star’s services are, especially when compared to the costs incurred by having to wait sometimes 60 or 90 days for a customer payment.

As noted before, the fees are deducted from the reserve held until the customer pays the invoice, and typically range from 1.5% to about 3.5% of the invoice amount.

The most important thing is to make sure you understand exactly what you will be charged. MP Star Financial doesn’t hide fees or surprise you with unexpected charges.

Examples of Accounts Receivable Factoring

Whether you’re a new startup, a well-established business, or a services company, invoice factoring can help solve the cash flow management problems that may be holding your organization back.

We recently released a revised version of our ebook on the topic. You can access it here: “Grow Your Business Through Invoice Factoring.”

Common Use of Factoring Receivables

As covered in a recent article, entitled “Invoice Factoring Tricks and Tips,” here are a few examples and common use of factoring receivables. 

By partnering with a factoring company, you can get the money owed to you in your receivables faster than you would normally collect it. This can help remove a lot of the headaches around how you manage your financials. Companies use factoring to help them stay current on payroll, to make their tax payments on time, to pay vendors on time, and to meet other obligations. Also, factoring can help fund growth.  

For example, janitorial and contract cleaning companies often are forced to turn down business – and opportunities for additional growth – because they lack the cashflow to cover any increases to their week-to-week business expenses, plus owners are often hesitant to take on additional debt.

To grow the business, they might need to add more staff, buy more equipment and supplies, and have enough money to fund a larger payroll – all this before that big new customer pays their first invoice. Invoice factoring can be a valuable financial tool, helping leverage the invoices and income you already have coming in, instead of adding additional debt.

For both startups and growth-obsessed businesses, factoring invoices can allow your company to take on more business that it may not otherwise be able to handle. Many times, companies do not have the financial strength to fund the startup, payroll and other expenses, then wait 30, 60 or 90 days to get paid. The profits might be there, but the startup cash needed – to get to the profits associated with the new business – is not.

That is where factoring comes into the picture. You do not have to wait for your accounts receivables to fund growth. You can use your existing business to fund your growth with factoring.

Why Do Companies Factor Receivables: Benefits of Using Accounts Receivable Factoring

The most obvious benefit of factoring receivables is not waiting for your customers to pay you. But there are other benefits, too.

• Simplifies collections: Business owners say collecting on receivables is one of their most difficult and time-consuming tasks. A factoring program from MP Star Financial gets you out of the receivables business and lets you focus on serving your customers and running your company.
• Immediate cash: You can get money quickly from accounts receivable factoring of eligible accounts at any time and can be paid the same day in many cases.
• Supports startups: MP Star understands how small businesses can struggle financially. Additional financing through factoring can be the ideal solution allowing you to leverage your customers’ credit to build your business. (And yes, we work with startups.)
• No additional debt: Credit lines with banks can take a long time to establish, are usually inflexible, and are generally limited by what your company can assign as collateral. When factoring receivables with MP Star, you get fast service and flexible financing.
• Builds your credit: With factoring loans and asset-based lending, your company will have the cash flow to pay its bills in a timely fashion-ultimately building its credit score, which allows you to leverage your suppliers for better terms.
• Supports a nimble approach to growth: Factoring lets you take advantage of business opportunities on a timely basis. Because you’re not waiting to be paid, you can fund equipment upgrades, purchase materials and supplies, and hire new staff as soon as you need to. Factoring receivables can put you back in charge of your company’s future.
• Allows for extension of credit: Invoice factoring enables you to extend your receivable terms to land the big accounts. It can be tough when customers continually find ways to extend payment beyond 30, 60 & 90 days. Even when you’re confident the invoices will be paid, your customers may have systems or practices that cause delays – like outsourcing their accounts payable departments to India, or mailing your checks from the opposite coast to play the float. 
• Supports you to take advantage of “early pay” discounts: Your customers are regularly taking advantage of the “two ten, net 30” terms that you offer, so why shouldn’t you? Receivables factoring gives you the cash you need to take those discounts and enhance the bottom line.

Invoice Factoring Versus a Traditional Bank Loan or Lines of Credit

Sooner or later, your growing company is going to need more cash than it currently has on hand.

• Maybe business is just slow due to economic, industry, or seasonal factors beyond your control.
• Maybe you’re caught on the wrong end of a slow-paying client/supplier relationship.
• Maybe you were forced to absorb unanticipated expenses due to personnel, equipment, or supplier issues.
• Or maybe your quarterly payroll taxes snuck up on you.

Running into a cash flow management crunch doesn’t always mean you’ve done something wrong, but it does mean you have to decide how to get the funds you need – and fast.

Options available to many business owners are a traditional bank loan, a bank line of credit and invoice (or receivables) factoring. Before you take the plunge into either alternative, make sure you’re aware of what they both can mean to your company.

Traditional Bank Loan

When businesses need money, both traditional bank loans and factoring may come up as possible solutions, but the two are as different as night and day. Traditional bank loans are more rigid and “cut and dry” as compared to the greater flexibility of factoring.

With bank loans, your business must present specific documentation and proof of financial performance along with other paperwork. They might also require business or personal property as collateral to secure funding. Once the details and paperwork are submitted, the bank will decide whether or not they will approve your request for a loan. The process can take weeks and even months to complete. 

Factoring is faster and more flexible. Because you’re gaining cash in advance of invoices paid, there is less paperwork and fewer requirements and limitations. 

While the traditional bank-lending process is arduous, it is seen as necessary to minimize risk that you might default on the loan. If the bank has any questions or doubts, they will either deny your loan request or charge you extra for the money you borrow (higher interest rates, additional fees, etc.). This is especially challenging for startups or businesses with a less-than-perfect financial track record.

In some cases, bank lenders will place restrictions as to how the loaned funds can be used. For instance, the bank may require the money go toward equipment, vehicles or furnishings versus payroll expenses or marketing. They might also stipulate that your business does not incur additional debts. In other words, even if you make it through the hoops, take the time and get the money, traditional bank loans may place limits on how you can use it.

Bank Line of Credit

A bank line of credit is a source of funding extended to a company to help meet its liquidity needs. It is generally intended to be a short-term arrangement. After approval of a certain amount of credit, it can be tapped at the company’s discretion. Interest is paid only on the funds actually borrowed, although some banks charge fees to establish the credit line and may also require you to pay an annualized fee on money not withdrawn.

Pros

• When interest rates are low, lines on bank credit lines generally follow. If you must borrow money, there are certainly better times to do it than others. Tap your line when money is cheap! (Of course, the reverse is true, too. And whatever the interest rate environment, your company’s credit history will also be a factor in the rate you pay.)
• A line of credit can help solidify your relationship with your bank, and prompt payments will enhance your company’s credit standing.
• The credit line’s convenient, “as needed” status gives your company almost immediate access to funds at any time. You might also eventually be approved for additional funds if you keep your account in good standing.
• Lines of credit are usually unsecured, meaning that business or personal property does not generally need to be collateralized to secure funding.

Cons

• Lines of credit can be tough to obtain, depending on general economic conditions and the commercial lending climate. You’ll have to provide the potential lender with a lot of business, and perhaps personal, financial information.
• Bank lines of credit aren’t necessarily forever. Changes regarding the amount available on your credit line, your interest rate, associated fees, and other matters pertaining to your credit line can be imposed by the bank, and you may not like them.
• Even when interest rates are low, bank lines of credit, over time, can turn very expensive. Much like a consumer credit card, interest charged on outstanding balances can accumulate to substantial amounts of money.
• By definition, a bank line of credit adds debt to your company’s balance sheet. Debt service that hangs around too long impairs your company’s flexibility and ability to grow and can hurt your ability to service other obligations that would be more beneficial to your company.

Invoice Factoring

Invoice factoring lets you sell your company’s receivables to a third-party, like MP Star Financial for fast payment – often the same business day – in exchange for modest transaction fees. No additional debt is created. Invoice factoring can dramatically improve your company’s cash flow. Rather than waiting up to 60 – or even 90 – days for loan monies to be approved and paid, factoring can give you access to your funds almost immediately.

Pros

• An invoice factoring arrangement is easy to set up. After some initial paperwork, a factoring relationship can usually be established in just a few business days.
• As a business owner or operator, you know that collecting on receivables is one of your most difficult and time-consuming tasks. A factoring program gets you out of the collections business and lets you focus on serving your customers and running your company.
• Invoice factoring means no additional debt for your company.
• Factoring finance lets you take advantage of business opportunities on a timely basis. Because you’re not waiting to be paid, you can fund equipment upgrades, purchase materials and supplies, and hire new staff whenever needed.

Cons

• The amount available to your company when you factor an invoice is – necessarily – directly tied to the amount owed on the outstanding invoice. (Of course, any funding arrangement is determined by the ability to repay the amount loaned.)
• The rate your company is charged can be influenced both by your company’s credit rating, as well as that of the companies whose invoices are submitted for factoring.
• You need to use good judgment regarding which invoices are chosen to be factored. Your fees will increase, at least slightly, the longer an invoice remains outstanding. For this reason, be careful about which invoices you submit. 

Do I Qualify for Factoring?

The fastest way to see if you qualify for factoring is to submit an online application to get the process started. There is zero obligation. Once we have your information, we will be in touch to discuss your unique situation and make recommendations to help support your goals and needs. 

Top 5 Tips for Factoring Receivables from the Experts

1. Ask for referrals, then ask for references. Remember what they say about an ounce of prevention. If you’re careful about who you work with, you’re much less likely to run into trouble later. Ask your accountant or another business associate you trust to recommend a few reputable factoring companies. After speaking with each factoring company, ask for the contact information of current clients. Prepare questions and explore the relationship as much as possible.
2. Only work with a factoring company that uses a bank lockbox, as opposed to a private lockbox or a post office (P.O.) box. Bank lockboxes timestamp all payments, and you can request a copy of a check from the bank lockbox the event that you are concerned. Factoring companies know this, and an ethical factor will provide timestamped checks upon request. If payments seem to be taking too long, banks provide detailed reports (upon request) on when checks arrived. This will help you, too, make sure your customers payments are being applied on time and you are not being improperly charged with clearance charges.
3. Super low rates come with a catch, such as monthly minimums or inactivity fees. Look for a factor that is flexible and will work with the ebb and flow of your business. Don’t be fooled by high credit limits being offered. As flattering as it might seem to receive a credit limit that far exceeds your needs, it may be a clue that your proposal includes monthly minimum fees. Monthly minimum fees are often calculated by multiplying your “high credit limit” by your factoring fee for a month, so your minimum factoring fees (regardless of your activity) will reflect your credit limit.
4. Watch your aging receivables carefully and keep after your collections. Time is definitely money in factoring – the faster your collections come in and get posted, the lower your invoice factoring fees will be over time. Do not fall into the trap of losing track of your receivables. Nobody, including the very best factoring company, will care as much as you about collecting your money. Staying on top of your collections will help minimize your factoring fees.
5. Keep a copy of your contract, along with any addendums, in a safe place. If there is ever a dispute, you will need to have this agreement to review. In addition, if you do have a long-term agreement, you will need to refer to the contract and any addendums to know when you are eligible to terminate your agreement.Note that many times the term of the contract is reset with each addendum (versus contract start date), and the date on the latest addendum dictates when you are eligible to terminate the invoice factoring relationship. This last point is very important, if you sign a one-year agreement today, many contracts require as much as 30 to 60 days’ notice prior to the anniversary date of the contract or the latest addendum to terminate or renegotiate the terms or it is renewed for another year. Long-term contracts are designed to benefit the factor, not you, and should be avoided.