Invoice factoring can be a extremely shrewd way to obtain reoccurring capital for your growing small to medium sized business. Fast, effective and accessible, factoring receivables enables firms in a range of industries to have regular access to business working capital. These industries commonly include companies from: freight, transportation and trucking to technology, telecom and business services, and so much more.
Though there are many advantages of factoring your accounts receivables such as: ease of use, no credit check required and fast funding. It does require a bit of a ramp up in terms of understanding how it all works. Learning some of the terms, procedures, and processes associated with factoring receivables, for instance, is one of the biggest challenges.
What Is invoice factoring exactly? A quick recap:
Factoring accounts receivables is an alternative financing method that enables a business to get capital by collecting on its invoices in a few days instead of a month. By selling your invoices to the factoring company, you get to collect on the invoice value without waiting for customer payment to arrive some 30-days later. The factoring company charges a fee for this processing and collects on the invoice from the client during the customary payment timeline (usually 30-days).
How risk level applies to obtaining commercial financing
Factoring is different from a loan in that it relies on the credit score of the customer rather than the applicant to determine creditworthiness. This is an alternative option to traditional banking and business loans. When loans are issued, the bank underwrites the loan and the applicant; this is a lower risk determination. When invoice factoring is issued, the company assesses and runs a credit check on the customer rather than the applicant. For this reason it is a higher risk endeavor than the traditional banking underwriting process.
Learning about risk can help you learn more about alternative versus traditional commercial financing options. The higher the risk the more you have to pay for alternative funding services. This is why invoice factoring is typically more expensive than bank loans.
Two different risk levels associated with factoring invoices
Factoring itself has two different options: recourse and non-recourse. Each selection has different risks and different costs. It is important to understand these two methods before entering into a commercial financing agreement. Let’s go over these two options:
- Recourse financing, the lower risk option, occurs when the factoring company divides the risk of client non-payment with your company. If your client fails to pay the invoice as agreed, you are responsible for repaying the full invoice value back to the factoring company. In this way, you are also responsible for performing the tasks and activities necessary for collecting the invoice from the customer.
- Non-recourse factoring, the higher risk option, is when the factor pays you the majority of the value of the invoice and lets you keep it even when the client fails to pay on the invoice. In other words, even if your customer never pays the invoice for the goods or services you have already provided, the factoring company will still pay you 70-80% of the invoice value. Essentially, the invoice factoring company will take all the risk and absorb the loss for you .
Pros & cons of recourse and non-recourse financing:
There are advantages and disadvantages to recourse and non-recourse options so it is best to learn about both before deciding which one is best for your business.
- The primary drawback with recourse factoring is risk of customer non-payment. So if your customer fails to pay the invoice, you have to pay back the money you collected from the invoice factoring company AND take whatever action is necessary to collect payment from your customer. This puts you right back where you started or possibly in a worse position.
- The positive aspect of recourse factoring is that if you have a long-term client that has never missed payment and you have complete trust in them, you can save some money by choosing a company that offers the recourse factoring option.
- The downside of non-recourse factoring is that it is a bit more costly than recourse generally speaking. Yet if you have a new client who hasn’t established a solid payment record with you or you just don’t want to deal with the hassle and aggravation of having to repay a collected payment, non-recourse factoring might be a better fit for your business.
- Many companies that process several large-dollar value invoices per month tend to prefer factoring without recourse for its added convenience and peace of mind. Moreover, many firms in trucking, freight and transportation prefer non-recourse financing because the industry has a large number of startups and small shops and is thus at greater risk for nonpayment.
Other differences between non-recourse & recourse funding
It is worth mentioning that many new or less established factoring companies opt to provide recourse factoring because it is lower risk than non-recourse financing. Factoring with recourse simply requires less financial depth or capacity than non-recourse factoring. Many large, multi-million dollar firms that provide factoring and other commercial financing services are non-recourse factoring. Moreover, it is the mostly commonly offered variety of factoring.
Now that you know the main differences between recourse and non-recourse financing, you can best decide which to use for your business. Don’t be afraid to search around and ask specific questions about rates and processes for non-recourse and recourse financing. Typically, the better, more established companies will have zero issues providing details on the services they offer.