Accounts receivable factoring is a way for small businesses to maintain their cash flow while they are awaiting payments from their customers. It works by selling the outstanding invoices or accounts receivable to a factoring company. The factoring company pays out 80 percent of the invoice to the small business and then collects from the customer. Once they receive full payment, they send along the other 20 percent minus their factoring fees. This gives the small business cash right away instead of waiting the normal 30 to 60 days.

Explanation

This is often a crucial and business-saving option for many businesses, particularly when they just becoming established. They will have likely used up all of their available credit and lines of credit from the bank to get their business up and running.

Accounts receivable factoring allows them to focus on continuing to support, and to build and grow their customer and client base while someone else tracks down their payments. It also doesn’t take away or diminish their credit or damage their credit rating because the only credit at stake is with the people who owe money on the invoices. Small businesses love factoring as well because it frees up cash to expand current production or hire and train new staff.

Here’s how accounts receivable factoring works.

💸 Step #1: Setting up the factoring system

The first step of the process is to get approval from a reputable finance company to determine if your company can be financed through accounts receivable factoring. The finance company will review the credit record of your clients and your current financial status.

💸 Step #2: Getting ready

Once the accounts receivable factoring account is approved you can select the clients and receivables that will be funded. Then their invoices can be submitted to the factoring company along with a schedule of accounts document and a formal request for funding.

💸 Step #3: Sell and invoice

Once you have provided products or services to your customer you issue an invoice for them to pay you. To qualify for factoring, these invoices must be payable within 90 days and are usually on a 30 to 60-day payment basis.

💸 Step #4: Send to factor

Then you send off the invoices to the factoring company who will determine their eligibility based on your previous discussions and arrangements. They will check on the customers you’re invoicing to ensure that they are good credit risks. The factoring company will then accept the invoices.

💸 Step #5: Getting paid: The advance

The factoring company will then send you payment of 80 percent of the submitted invoices. If the total invoice was $10,000, they would send you $8,000 as your advance. This is an advance against full payment. It is almost always 80 percent of the submitted invoices, but it can be more or less depending on the size of the transactions, the industry, and other risk parameters. They will also let your customer or client know that they have assumed responsibility for ensuring payment.

💸 Step #6: The customer pays the factoring company

The customer will pay the factoring company the full amount of the invoice within the prescribed period. If they do not, the factoring company will follow up. They have assumed responsibility for collecting on this invoice.

💸 Step #7: Getting paid: The remaining balance minus fees

Once the factoring company receives the full payment of the outstanding invoice from the customer they send you another payment. This represents the remaining balance of the invoice, called the reserve amount, minus their fees. Factoring fees can range from half a percent up to five percent in some cases. If the factoring rate was three percent then they would charge $300 on the invoice of $10,000, so your final payment would be $1,700.