When making decisions, a company should consider all the potential short-term and long-term impacts on the business, not only to keep surviving on the market but also to succeed, grow and generate competitive advantages. It is common, in the business world, for companies to seek funding solutions on a continuous basis to smoothly run their operations, fulfill their orders as well as maintain and gain market shares.
Traditionally, a bank loan is the first option to get additional working capital for a company. However, most companies are not eligible for a bank loan, especially when they haven’t existed long enough on the market. Fortunately, several alternative funding solutions are less traditional which can help these companies get the funds to support their cash flow. Factoring is one of the most common funding solution companies seek when they are unable to get a bank loan; it is both easier to qualify for and quicker to finance their immediate needs.
What is Factoring?
Factoring also referred to as Invoice Factoring or AR Factoring, is a branch of Asset-based Lending (ABL) that generates a financial transaction in which a business chooses to sell its accounts receivable to a factor at a discounted price to meet its financial needs. The factor can offer same day funding by providing an upfront payment to the business, up to 90%. This is based on the invoices amount and depending on the industry.
In due time, the factoring company receives payment from the end customers who are liable to pay and returns the remaining balance to the business client. Such balance already subtracts the already procured amount and service fees. Therefore, Invoice factoring not only supports businesses to retain a continuously available steady cash flow but also enables them to take advantage of growth opportunities.
There are two existing ways to factor: Recourse Factoring and Non-Recourse Factoring. Distinguishing between these two ways is very crucial. There is a great deal of information on the internet about recourse vs. non-recourse factoring. However, much of it is wrong. When choosing a Factoring Company, it is vital that you understand what you are being offered.
What is Recourse Factoring?
Recourse makes up 88% of the AR financing industry according to the International Factoring Association. Recourse factoring is an agreement between you and your factor. In a recourse factoring, the company is responsible for recovering the cost of any invoices your liable customers fail to pay. Meaning, if your client does not pay the invoice by a specific date, the Factoring Company can charge that invoice back to you, or you can replace that invoice with another good invoice. In some ways, this is similar to a line of credit from a bank with a borrowing base as one of the loan requirements. If an invoice becomes unpaid, for example, longer than 90 days a bank won’t let you borrow against it, or a factor will ask you to replace either the advanced funds or give them another good unfunded invoice.
What is Non-Recourse Factoring?
With Non-recourse factoring, the factor accepts the non-payment credit risk of your customers. Businesses that don’t qualify for Recourse Factoring can consider Non-recourse Factoring. Thus, the Factoring Company gives you a credit guarantee that they are responsible for the collection of your invoices. It might be all your invoices or just those from certain clients. Typically, this guarantee is valid in case your client files for bankruptcy. This is a critical point as it is essential to understand that it is not a guarantee that you are protected for good or services that your client disputes for not meeting specifications. However, this “insurance policy” against bankruptcy is critical for your survival. Linens n Things, Circuit City, FAO Schwartz, Adelphia, Delta Airlines, General Motors are all examples of companies that filed bankruptcy that was once thriving. You never know which one of your clients will fail.
How to Choose between Recourse and Non- Recourse Factoring?
When comparing these two types of factoring, it seems that the major difference is the party who is at a bigger risk for bad debt. Once you understand this difference, you can make the right choice for your business.
This option is not as risk-free as non-recourse factoring. However, it generally costs less. When your client fails to pay or has delinquent invoices for more than 90 days, your business will have to repurchase the invoice from the factor to cover its cost.
What are the Benefits of Recourse Invoice Factoring?
- Fast cash for your immediate needs;
- Not a loan meaning no debt on your balance sheet;
- Don’t have to handle any collections;
- Stimulates your cash flow.
Non-recourse is when a factoring company engages to take on full responsibility when buying your invoices. This means that it takes the risk of bad debt. The factoring company is in charge and will have to take action if your clients default and fail to pay in agreed due times. This is beneficial for your business if you lack the time, money and resources to take on the responsibility of collections. Once your invoices are sold to the factoring company via non-recourse factoring, you are not liable to cover any cost of your clients’ non-payment issues. You won’t have to worry about buying back any invoice from the factoring company if it is left uncovered; meaning that the upfront payment advance you receive on your invoices, is 100% credit risk-free.
What are the Benefits of Non-Recourse Factoring?
- Same Day Funding;
- Available working capital;
- No extra debts;
- No Credit Risk
In addition to providing working capital and credit information; protection from a large bad debt is one of the most important services an Invoice Factoring Company can provide. When deciding on a Factor, make sure they offer bankruptcy protection. Many smaller or under-capitalized factors cannot get credit insurance. This fact alone should make you think twice about your choice of a factoring company.