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Choosing a Factoring Service for Your Business

What do you do when you find yourself in need of capital, but can't get (or don't want) a traditional bank loan? For business owners in need of fast cash, using a factoring service may be the answer.

Factoring is an alternative method of finance that allows business owners to sell their invoices, or accounts receivable, to a third party commonly known as a factor. Invoices are sold for a certain percentage of their total value. This means you'll receive most of the payment for goods or services you provide to your customer base almost immediately. The factor then collects your customers' payments and forwards the rest of the cash to you, less the company's service fee.

This approach to financing is attractive, as it allows you to receive cash almost immediately, regardless of the size of your business or its track record. In addition, you may be able to factor more than you can borrow through a commercial lender as long as you have an adequate stream of valid invoices for reliable accounts. But in some circumstances factoring isn't always a viable option.

How it works

After handing over copies of your accounts receivable, the factoring service pays you between 70 and 90 percent of the total invoice value within two to five days of receipt. If the factor you select accepts electronic invoices, funding may be available in as little as 24 hours.

But before accepting your invoices, the factor will conduct due diligence to determine the creditworthiness of your customers and whether or not they will be capable of paying their invoices on time. This is an essential step, as the factor typically does not function as a collection agency. To qualify for factoring, accounts have to be in good standing.

After accepting your customers, the factor reviews all outstanding invoices and inspects them for accuracy and completeness. If all signatures are in place and the invoices have been properly issued, the factor requests payment from your customers by sending them a notice of assignment. This informs the customer of the service you're using and instructs them to send all future payments directly to the factor.

Once payment has been made, the factoring service transfers the remaining balance owed on that particular invoice to you. The service also deducts its fee (also known as a discount rate), which is usually between 2 and 6 percent of the invoice total. It's worth noting that the individual factor and particular structure of the deal you sign up for will affect the discount rate. For example, some factors may offer up to 90 percent of your accounts receivable upfront, but charge a 6 percent discount rate. Others may provide 80 percent upfront and assess a 3 to 4 percent fee.

To help you track your revenue and expenses, many factors now provide online access to your account. This enables you to keep tabs on the process in real time, from notice of assignment to final payment.

Benefits of using factoring services

The most notable benefit of using a factoring service is that it gives you almost immediate access to the cash you need - making it easy to fund a product launch or growth initiative. However, there are many other positives that make factoring a great funding option.

  • No collateral required - Factoring services do not require collateral in the form of property or business equipment. They conduct their due diligence on your customers, and that is the basis for the most common factoring agreements.

  • Simplified accounts receivable - A factoring service takes over the entire process of collecting on your invoices. This eliminates the time you would be spending on collections as well as the on the management and reconciliation of invoices. It may also cut down on wait time. Without factoring, you may be forced to wait 45, 60 or even 90 days to collect.

  • Ideal for startups - When it comes to traditional business loans, the pressure is on you and your business to prove that you will be able to repay the loan. This can be tough for startups, small businesses or those without the necessary cash flow. But with factoring, it's not about you - it's about your customers.

Things to consider

There are two potential downsides to using a factoring service. The first is that it can be more expensive when compared with other financing options like traditional bank lending. The service fee may seem small, but it can add up, depending on how much you have in outstanding invoices and how long it takes to collect on them.

That said, the steeper price may be worth it. Factoring can be a perfect working-capital solution as long as the opportunity cost outweighs the factoring cost.

The second concern is that factoring may not work for companies that have on-going relationships with their customers. Some clients might not take kindly to having their invoices handed off to a third party which may not treat them the same way you would if you were trying to build a strong bond with them. Factoring may be better suited to businesses that don't often have repeat customers or for whom building strong customer relationships is not a priority.

To help determine if it's right for you, look at the opportunities you may be missing by not factoring. In particular, keep in mind the launch initiatives or growth opportunities mentioned above. It's important to view factoring as a financing strategy conducted over a period of time. Within this framework, realize that it can help you expand or recover while achieving specific long-term goals.

Generally speaking, factoring is only beneficial to those with a reliable client base, which means businesses that have a net 30 or net 60 payment structure. Factoring is not a solution for companies in dire financial situations. If your company has substantially more accounts payable than accounts receivable, factoring is probably not a good idea.

Collection agencies vs. factoring

Factoring services are commonly confused with collection agencies. But there is a substantial difference between the two. A factoring company advances you funds based on outstanding invoices owed to you by creditworthy customers. A collection agency assumes the debt of a past-due invoice and attempts to collect it for you through letters, phone calls and legal processes when applicable.

This general purpose is one of the primary differences between the two services. Factoring supplements periods of poor cash flow you may be experiencing by providing funds for a large percentage of your qualifying receivables. This saves you from having to wait the 30, 60 or 90 days some businesses require to submit payment. Contrast this with debt collectors who are attempting to recover old debt - invoices that have gone beyond the accepted payment window. With this setup, you receive nothing upfront and only receive a percentage of the debt after it has been successfully recovered.

Other notable differences include:

  • Timing. The process of factoring can be expedited by the creditworthiness of your clients and the way you have your account set up. With reliable clients and an electronic account, you can have the majority of your receivables settled within 24 to 48 hours. This is not the case with debt collection. In an ideal scenario, the delinquent client may settle after receiving the first letter (one to two weeks in). If not, the agency will follow up with phone calls and legal action - a process that can take months.

  • Costs. Fees provide another clear difference between the two services. As mentioned above, you can expect to pay from 2 to 6 percent of your total receivables for factoring services. Debt collection may take 20 to 30 percent of the amount collected.

Bank lending vs. factoring

Far more similar to factoring than debt collection, bank lending is a form of financing based on your creditworthiness as the business owner. Also known as asset-based lending, the bank variety provides funds secured against your business assets, including property and industrial equipment.

In many cases, the guarantee can be issued against the very item you're seeking funds for - equipment, for example. In these instances, the lender will determine the total funds you qualify for by assigning a borrowing base - a percentage of the market value for the assets you hope to acquire or currently hold. This figure is usually 50 percent of the total value or less. The same lender may also offer a line of credit on your accounts receivable between 70 to 90 percent of their full value.

It's worth noting that a line of credit is continuously in flux, with a borrowing base that may shift from month to month. Affected by new invoices submitted for payment as well as payments received on older invoices, this system is often available only to businesses with an established track record and that hold valuable assets.

In contrast, factoring services shift the focus away from the history of your business and place it on the value of your accounts receivable. As covered in detail above, this process provides immediate payment on invoices that could extend to net 60 and beyond.

One notable difference between the two financing methods is that asset-based loans typically start around $700,000 and are commonly in the $2 million to $25 million range. By comparison, there is no minimum for a factoring service, making it ideal for small businesses and startups.

The final distinction between the two may be the biggest: cost. Asset-based loans are more costly over the long term because they operate on an annual percentage rate (APR) between 5.6 and 8 percent (usually figured as prime plus 2 to 5 percent). This is in contrast to a factor that takes 2 to 6 percent of the value of the entire invoice or 0.6 to 1.2 percent for every 10 days that invoice remains unpaid.

When comparing factoring services, there are two main classifications and an assortment of various types. The two main categories are:

  • Recourse factoring - The most readily available and also the most common and cost effective. In this type of setup, the factor funds your invoices but requires you to provide a refund on any invoices that remain unpaid past a certain amount of time. On top of that, the factor also charges a fee. Since you assume more of the risk with recourse factoring, you'll be able to obtain much more competitive rates.

  • Nonrecourse factoring - Essentially the opposite of recourse. It releases you from any liability for delinquent accounts. Since the factor is willing to take on substantially more responsibility and legwork, this type of factoring is always more expensive. In addition, the creditworthiness of your clients will be more closely scrutinized in nonrecourse factoring as the factor looks to avoid potential loss via uncollected invoices.

Within these two main factoring categories, there exist a number of different types designed to address specific business situations and needs. The following include the more common of these types:

Accounts-receivable financing

Falling within the recourse classification, this type of factoring leverages your accounts receivables as collateral to provide immediate funding. The purpose of this type of factoring is to free up capital that is trapped in receivables while shifting your business focus away from collections and onto growth, product development or another area of importance.

Unlike nonrecourse factoring, the factor may be willing to accept older invoices. But the older the invoice, the higher the discounted rate you can expect to pay.

Invoice factoring

Popular for its ability to eliminate bad debt, invoice factoring allows your company to turn over accounts receivable to a factoring service that will assume all of the risks associated with uncollected invoices. Somewhat similar to nonrecourse factoring, it differs in one critical way. Invoice factoring acts in a way that's similar to a line of credit: The factor (known as a financing factor in this case) offers immediate funding, which is secured by the goods to be manufactured using the capital provided.

Accounts-receivable discounting

This is another hybrid of factoring and a line of credit, and there are actually two different varieties. In the first type, the lender provides a short-term loan using your accounts receivables as collateral. Similar to recourse factoring, a discounted rate applies and the total value is usually in the range of 80 to 90 percent. This is the total amount of funds your business would qualify for. Unlike a standard factoring process, the invoices are not purchased outright, but rather only used for the security of the loan.

The second type is similar to nonrecourse factoring in that the lender will actually purchase the invoices and will be responsible for collecting them. Given the extra liability, the total value of your accounts receivables for services of this type is usually between 70 and 85 percent.

Debt factoring

Combining nonrecourse factoring with debt-collection services, a debt-factoring service assumes responsibility for uncollected invoices, immediately providing partial funding on the invoices while eliminating bad debt. This type of factoring can be more costly than others, as the factor will first explore your business operations to assess the difficulties involved in collecting on your receivables. This process will be used to calculate the discounted rate you pay, with a total value that's commonly between 70 and 85 percent.

Maturity factoring / collection factoring

Sometimes known as service factoring, this type turns over more control of your accounts receivables to the factor. Within this setup, the factor manages your invoices, customer credit and payment schedule, and provides funding (less the discount rate) on all invoices as they come due, whether or not the customer has actually remitted payment.

Full advance factoring

Another form of nonrecourse factoring, this type advances the entire value of your invoices, less the discount rate, upfront. Similar to nonrecourse factoring, the factor assumes all liability for collecting debts. But unlike other forms of factoring, the payments are not split into two disbursements: one paid immediately and the other after the invoice has been paid. With full advance factoring, you get everything at once.

This type of service is extremely rare - few factors offer it because few customers are able to qualify for it. Qualifications typically include an exemplary credit score and a long track record of payments made in full.

Bulk factoring

Highly similar to recourse factoring, bulk factoring provides financing based on the total value of accounts receivable, a figure that's commonly around 80 percent. Also known as in-house factoring, it's a process that allows you to take advantage of the financing opportunities of a factoring service, yet maintain control of all operations related to your accounts receivables.

Used mainly as an alternative to a bank loan, bulk factoring requires you to do your own collecting and therefore saves little in the way of time and legwork.

Factoring fees

Up to this point, we've been looking at a generalized percentage range when referring to a factor's discount rate. To recap, it's typically between 3 to 6 percent but may be presented as anywhere from 1 to 5 percent. It's important to understand that there is a lot more involved with the discount rate than just the creditworthiness of your customers.

To determine the rate a factor will offer you, the service will consider a number of different business indicators. These include:

  1. Invoice volume: The more invoices you bring to the table and the higher their value, the lower the discount rate.

  2. Customer base: When it comes to your clients, businesses are preferred to individuals simply because they tend to have a cash flow that allows them to pay their invoices faster. A roster of established companies with a track record for paying their invoices in full will earn you a much better rate than if individuals owe most of your accounts receivable.

  3. Industry risk: Unfortunately, a factor does not view all industries equally. The disparity is largely due to the higher risks involved with billing recovery. Common examples include clothing, and medical and construction, which typically receive discount rates on the higher end of the scale and upfront total values on invoices as low as 70 percent.

  4. Client credit history: While most factoring services do not take your credit score into account, they do consider the creditworthiness of your clients. Business credit - or trade credit as it's known - is measured on a score from 0 to 100, with 75 or higher viewed as exemplary. The factor may assign a higher discount rate to businesses that have a lower credit score; some nonrecourse factors will refuse them outright.

  5. Billing considerations: If the nonrecourse factor accepts a customer with a less-than-stellar credit history, you can be guaranteed to get a higher discount rate. The factoring service is assuming more of a financial risk by taking that customer on - a process that often results in an extended wait for full payment as well as repeated billings or account maintenance. Progress billing, or incremental payments made throughout the course of a lengthy or sizeable contract, also falls under this category, due to the extra management such arrangements require of the factoring service.


When you enter into a factoring agreement, most providers require you to sign a contract that holds your accounts receivable as security and works in lieu of physical collateral. Within this contract, there are a number of things to watch out for and even a few ways to use the arrangement in your favor.

Pay attention to:

  • Terms of sale - This section represents the general terms of your agreement, including the advance rate (the amount you receive upfront based on the total value of your invoices), the discount rate (a fee of 1 to 6 percent assessed by the factor for the company's services) and the reserve amount (the balance remaining that is funded once the invoice is collected). Terms of service will also include how frequently you intend to use the factoring services.

  • Discount rate - When factoring services advertise, it is common for them to tout a discount rate of 1 percent or less. What these ads may not include is the period of time that rate covers. Low rates are often only extended for 10 days. This means that an invoice that takes 30 days for collection will actually result in a discount rate of 3 percent; that rate will jump to 6 percent for collection within 60 days. Know the number of days your discount rate covers and make sure the invoices you submit for factoring can reasonably be paid within that time frame.

  • Default provisions - This is where factoring can get costly. In short, default provisions are the factor's safeguards against unpaid invoices, as most are not willing to serve as a collection agency. After a certain period of time, outstanding funds become "immediately due and payable." This requires you to assume the loss for the unpaid invoice and repay the uncollected amount to the factor. Though each provider offers a different grace period, the standard default for outstanding accounts seems to be about 12 months.

  • Specific invoices - Finding the best deal is often simply a matter of being selective with the accounts receivable you present for factoring. Generally speaking, the system will be most profitable for you if you have invoices due within the following two to 10 weeks and have business clients that pay in full on the due date or shortly thereafter. Avoid those with lengthy payment terms or an unreliable payment history.

What to look for in a factoring company

Factoring companies often specialize in businesses operating within a certain niche, size or annual revenue. While you may qualify for a range of factoring services, not all will provide the same level of service and cost effectiveness.

An easy way to compare the strengths and weakness of a factoring service is to search for reviews online or ask to see references provided by existing customers. This will give you a general overview of the level of service provided.

To determine whether the factor you're considering is a good fit for your business, it's important to speak with a representative from that service. This provides an opportunity for you to ask any additional questions. More important, it provides a window into the level of service the factor provides, including everything from responsiveness to professionalism.

These are critical concerns, as most factoring services will be in direct contact with your customers and are often viewed as an extension of your business. Ask to see sample copies of the different types of communication routinely sent to customers, including emails and letters. Some may even let you listen in on a phone call. The purpose of this is to add weight to those services that mirror your core business values.

Setup costs

This is another area that can be a surprise if you're not expecting it. But it's also an area that may be negotiable. When comparing factors, ask about any setup costs involved with establishing an account. A common example includes a one-time fee of $500 for basic application processing to a minimum of $2,000 to process your application and conduct all due diligence, including inquiries related to tax liens, credit report and client invoice validation.

By Sylvia Rosen, Senior Editor businessnewsdaily.com
Brittney Helmrich and Sara Angeles also contributed to this story.