Factoring, or invoice factoring is a financial service where a business sells their account receivables to a factoring company for an advance on payment due for product/service already rendered. The factoring company will issue a large percentage of the invoice to the business. Then, they handle payments with your customers directly. The factoring company will send the remaining percentage, minus a factoring fee, after receiving the payment.
When seeking this financial service, a business will have the option of choosing between two types of factoring: non-recourse factoring and recourse factoring. Recourse factoring tends to be the more favored option of the two. Under this factoring agreement, if your customer fails to pay their invoices to the factoring company, your business will be held responsible. If the factoring company does not receive payment from your customer for their invoices, your business will be held responsible under this factoring agreement.
Example of Recourse Factoring
If Company A (your business) sells $1,000 worth of products to Company B, with repayment due within 30 days. Company A needs the money before the 30 days set for payment, therefore selling their invoices to a factoring company. After the 30 days, Company B has only paid $850 and is not making any effort to repay the factoring company. The factoring company may demand the remaining $150 balance as compensation from you.
A more serious example could be supposing you factored your account receivables of $20,000, and the fee decided between you and the factor company was 7%. The total payment that the company received from your client was $11,000. The factor company was forced to withhold the excess security sum from you, since the debt exceeded the security amount. Failure to pay this to the factoring company may result in recognition of this negative payment history in your next income statement.
Approval qualifications offer more flexibility compared to traditional lending. You will be responsible for ensuring that your customers pay. For the application, factoring companies may review you and your customer’s credit and payment history. Although credit score is not a priority factor, the company will want to evaluate the risk factors.
This is nearly the opposite for non-recourse factoring. Since the factoring company will assume responsibility for non-payment with non-recourse factoring, credit and payment history are evaluated more thoroughly.
Recourse vs. Non-Recourse Factoring
The fees or cost of factoring for recourse factoring is normally lower in comparison to non-recourse factoring. The advance amount tends to be high since the seller bears the risk. This is what makes the option for recourse factoring more favorable. Most factoring companies offer commercially reasonable requirements, making it easier for businesses to qualify. Faster disbursal of funding is also possible.
Collaborating with customers who have a poor track record of repaying their debts could pose a risk to your business. As you would have to reimburse the lending company and risk damaging your reputation with them. In other words, you will be held accountable and associated with the risks of non-payment. Factoring companies recommend businesses to only choose the recourse factoring option with reputable clients and/or a combination of multiple clients with positive payment history.