What is Accounts Receivable Factoring?

Cash flow problems are no joke. Research shows that as many as 82% of small businesses that fail in the Philippines, fail because of cash flow issues.

Luckily, there are ways to mitigate cash flow struggles. Philippine businesses have more than a few options available to them. Financing might be the obvious answer—take out a loan, repay the loan—but it might not be the best one.

For many, accounts receivable (AR) factoring is a better alternative.

AR factoring is when a company sells its unpaid customer invoices (accounts receivable) to a factoring company, usually at a discount. In exchange, they get the cash they’re owed upfront.

How does Accounts Receivable Factoring work?

In theory, it’s all pretty straightforward. A business has low cash flow, but they also have unpaid accounts receivable—money that they’re owed. Rather than wait for the customer to pay the bill, they sell it to a factoring company who then takes responsibility for collecting payment. Simple, right?

Well, here’s how that looks in practice:

• Invoice submission: The business submits its unpaid invoices to a factoring company—a specialist institution different from a bank.
• Verification: It’s up to the factoring company to verify the invoice. They’ll make sure it’s legit and also go over the business’ credit rating.
• Advance payment: All going well, the factoring company advances a percentage of the invoice (usually around 70-90%) to the client.
• Collection: Here, the business can essentially wipe its hands of the bill. The factoring company takes responsibility for collecting the payment from the customer.
• Final payment: Once the customer pays the factoring company, they’ll pay the reserve (the remaining invoice balance), minus factoring fees.

Talking of fees, there are essentially two ways in which Philippine factoring companies charge for invoice factoring:

• Discount rate: A percentage of the invoice amount, usually ranging from 1.5% to 5% per month, depending on risk and terms.
• Additional fees: May include service fees, administration charges, or penalties for slow-paying customers.

Types of Accounts Receivable Factoring

As always with financing, there’s more to AR factoring than meets the eye. To get a better idea of AR factoring before you take the plunge, it’s important to understand the two main types, recourse and non-recourse.

These two factoring types are tailored to different levels of risk and protection for businesses and factoring companies. Let’s take a look:

Recourse factoring

Recourse factoring gives the factoring company (the lender) recourse. Meaning the business (client) retains the risk of non-payment. If the customer doesn’t pay up, the business will have to return the factoring company’s advance.

Why would a company opt for recourse factoring? Well, the lender assumes less risk, meaning they offer lower fees, plus recourse factoring is cheaper.

Industries that commonly use recourse factoring include:

• Manufacturing
• Wholesale and distribution
• Retail supply chains

These are industries in which high-volume invoicing and extended payment terms are par for the course, making recourse factoring an attractive option.

Non-recourse factoring

With non-recourse factoring, the factoring company assumes the risk of non-payment. If the customer fails to pay, like in the event that they go bankrupt, the factoring company absorbs the loss.

With the factoring company taking a bigger leap of faith, they’ll likely impose greater restrictions, meaning you can also expect higher fees.

Industries that might use non-recourse factoring include:

• Healthcare
• Construction
• Export/trade

Such industries face higher risk of client defaults, insurance and credit risks, and even longer payment cycles.

Recourse vs non-recourse factoring: What's the difference?

Essentially, it’s all about risk. Specifically, who takes it?

With recourse factoring, the business legally retains the risk of non-payment. If the customer doesn’t pay the invoice, the business has to pay the factoring company back the advance. This has a few implications:

• Payment is not technically guaranteed, meaning you could lose money.
• It’s down to you to chase payments.
• However, it’s cheaper, as you’ll pay lower fees to the factoring company.

When accounts receivable are factored without recourse, however, the risk of non-payment is entirely down to the factoring company. The business basically sells this risk to the lender, but pays a premium. Here’s what that means for you:

• Payment is guaranteed, even if the customer never ends up paying.
• The factoring company pursues payment of the invoice.
• Higher fees and tougher credit checks, as the factoring company is taking all the risk.

Benefits of accounts receivable factoring

Some of the key benefits AR factoring offers include:

• Improved cash flow: Of course, the major plus with accounts receivable financing and factoring is that it alleviates those pesky cash flow problems. Instead of waiting 30, 60, or even 90 days for bills to get paid, you can get as much as 90% of that capital right now. That’s essential for paying expenses (like wages and supply payments), but also for investing in growth initiatives.
• Reduced credit risk: With AR factoring (at least with non-recourse factoring), there’s no risk of customer non-payment for the business. This can protect you from bad debts that might appear on your credit report.
• Outsourced collections: Don’t worry about the time or effort involved in collecting payments, simply outsource that burden to a third party. Don’t worry about your reputation, either as reputable factoring companies have professional collection processes in place.
• Easier approval than loans: Ever had to wait for a business loan from a bank? In the Philippines, this can take several months, which isn’t good if you’re having cash flow problems right now. AR factoring is usually much quicker, taking as little as 24 hours in some cases.

Healthcare and medical accounts receivable factoring

Some industries face unique challenges when it comes to accounts receivable. But these can also be industries that rely most heavily on AR factoring. Healthcare and medical would be two prime examples.

Healthcare and medical providers face long payment cycles and complex billing systems—a deadly combo for cash flow. Providers often have to wait 60, 90, even 120 days for reimbursements from insurance companies. That can make even day-to-day operations especially difficult.

That’s why medical AR factoring is so common. Providers can get 90% of their money owed upfront without waiting for a lengthy approval process. Another major benefit is that AR factoring doesn’t incur any bad debt.

With the risk of denied or delayed claims being so high in the healthcare industry, non-recourse factoring is a tempting solution. Sure, medical companies will have to pay more in fees, but they’re protected from non-payment, which ultimately reduces financial risk.

What does all this add up to? It means that medical AR factoring helps healthcare businesses stay financially stable while continuing to provide excellent patient care.

Cost of factoring accounts receivable

We’ve mentioned that AR factoring involves costs. It’s a great way to skip lengthy payment waits, but it’s not exactly free—after all, factoring companies need to make money, too.

Let’s look at some factors that affect the cost of factoring accounts receivable:

1. Industry type: It’s a simple fact, different industries have different risk levels and payment cycle lengths. Healthcare and construction, for instance, have long reimbursement times and pretty high default risks. On the other hand, industries like wholesale and manufacturing have more predictable cash flow. In general, higher risk equals higher factoring fees.
2. Invoice volume and size: Put simply, the more invoices you factor, the lower the cost per transaction. Factoring companies may offer better rates to businesses with consistent, high-volume receivables, as it improves efficiency and lowers processing costs.
3. Debtor’s creditworthiness: It’s not just the business, but the customer that the factoring company has to keep an eye on. After all, their creditworthiness, not yours, is the important factor. Poor credit ratings or inconsistent payment behavior can increase the cost of factoring.

Disadvantages of accounts receivable factoring

Let’s dig into some of the disadvantages of factoring accounts receivable:

• Loss of full invoice value: When factoring accounts receivable, you actually lose some money. That’s because factoring companies charge 1-5% of the invoice value (per month), meaning you’ll end up with less than the full invoice amount. Of course, you’re paying to get the cash now rather than later—whether or not you can afford the cut is up to you.
• Third-party involvement: For some businesses, the idea that a third party will deal with their customers on their behalf can be off-putting. If not managed carefully, it could signal financial instability or reduce trust. Although it’s worth noting that reputable factoring companies go about the process professionally and respectfully.
• Customer credit dependence: Approval and rates often depend on the creditworthiness of the client’s customers, not the business itself. That can leave you at the mercy of external factors when it comes to fees.
• Perception of financial weakness: For you, this may not be a problem. For some businesses, however, having to rely on frequent factoring could appear financially weak. Some worry it could affect their future financing opportunities, too.

When to use accounts receivable factoring

AR factoring is a useful fallback, but businesses should be wary of relying on it. Ideally, you want to get to a place where you don’t need to use factoring services at all.

Sometimes, though, especially for small businesses and startups, it’s unavoidable. Let’s explore some common scenarios wherein AR factoring could be the way forward:

• Cash flow issues: Cash flow issues are a big problem, and AR factoring is an answer. Businesses very often face delays in receiving payments. Factoring bridges this gap by turning invoices into immediate working capital, essential for covering expenses like rent and wages.
• Slow-paying clients: It’s a characteristic of the system that payments sometimes take 30-90 days to go through. Factoring eliminates that wait time—or at least reduces it to a day or two!
• Seasonal sales fluctuations: It’s normal for your business to experience seasonal highs and lows, but that doesn’t mean it can’t hurt your finances. During off-peak seasons, cash flow may dwindle, all the while, expenses remain constant. Factoring helps maintain liquidity.
• Rapid growth or high demand: While growing businesses scale, they may find it tricky to fund new orders or hire new staff. Factoring can help. By providing cash (which you’ve already earned) upfront, factoring companies help you scale without incurring debt.

Accounts receivable factoring vs financing: What’s the difference?

AR factoring and financing are two different processes, and their differences can have serious implications for your business.

Factoring

AR factoring is essentially when a business sells its invoices to a third-party company (the factor) at a discount. The factoring company then collects the payment.

Advantages of factoring:

• Immediate cash without creating debt.
• Outsourced collections reduce administrative burden.
• May include credit protection in non-recourse agreements.

Disadvantages:

• Loss of full invoice value due to factoring fees.
• Customer interaction with a third party may affect relationships.
• Perception of financial instability if used frequently.

Financing (accounts receivable financing or invoice financing)

Invoice financing is closer to borrowing. Here, the business borrows funds from a lender and uses its unpaid invoices as collateral. Crucially, the business retains full control over collection. They then repay the loan once the customer has paid the bill.

Advantages of financing:

• Retains customer relationships.
• Borrowing can be more flexible and confidential.
• You keep more control over your receivables process.

Disadvantages:

• Creates debt on the balance sheet.
• Requires repayment regardless of customer default.
• Interest and fees may accumulate over time.

How to choose the right factoring company

So you’ve decided on AR factoring. Now, it’s time to choose a factoring company. This is an important decision, as it could affect your costs.

Things to compare:

• Fee structures: Discount rates, hidden charges—how much will you end up paying
• Reputation: Scour the web for client reviews and look over their track record.
• Familiarity with your industry: Make sure the company understands the billing cycles and client behavior characteristic of your industry.
• Flexibility: Keep an eye out for long-term commitments and minimum volume requirements.

Conclusion: Is accounts receivable factoring right for your business?

Okay, it’s time for the big question: Is Accounts Receivable Factoring the right path for you? Only you can decide, but we can help illuminate the path a little.

Factoring, even when accounts receivable is factored without recourse, is a great way to get quick cash without incurring any debt. Plus, you can outsource collection for added convenience. However, it’s not without drawbacks: factoring can cost you over 5% of the invoice value and bring third parties into your client relationships.

Take the time to sit down and go through your needs before committing. There are plenty of options for business financing in the Philippines, so if factoring doesn’t fit the bill, you have other opportunities.

In the meantime, why not manage your finances more effectively with world-class accounting software? QuickBooks can help you invoice more effectively and avoid cash flow problems to begin with. Try it for 30 days free today!