Accounts receivable factoring: How it works & its impact on cash flow

Here’s a familiar scenario:

A big client just extended payment terms to 90 days, and cash flow grinds to a halt. As a growing business, you’ve got success tied up in unpaid invoices while costs—payroll, suppliers, rent, and the next big order—keep stacking up.

At the same time, banks may demand more collateral, and customers treat 60–90-day terms as standard.

It feels like an impossible choice: turn down profitable contracts or risk missing basic obligations.

When cash is needed now—not months from now—factoring is worth considering. It isn’t a quick fix or a miracle cure; it’s a practical way to unlock cash trapped in receivables. Understanding how it works and its impact on your cash flow is the key to deciding if it’s the right move for your business.

Let’s break it down.

Here's what this guide delivers:

• Clear cost calculations so you know exactly what factoring will cost
• Industry-specific guidance that tells you if factoring makes sense for your business type
• Real comparison data against bank loans and credit lines
• Red flags to avoid when choosing a factoring company
• A practical decision framework that shows when factoring helps versus hurts

What is accounts receivable factoring?

Beyond immediate cash, factoring enables businesses to pursue growth opportunities like investing in equipment, expanding product lines, launching marketing campaigns, or taking on larger contracts. It also mitigates risk by transferring collection responsibility to the factor, reducing exposure to delayed or non-payment and freeing up internal resources.

Factoring is particularly beneficial for rapidly growing businesses, as it's a non-debt financing solution that doesn't add liabilities to the balance sheet. Industries like manufacturing, wholesale, transportation, and staffing commonly use factoring to optimize working capital and achieve strategic financial stability and growth.

This process involves two main parties:

• The business: This is your company, which has delivered goods or services and is waiting for payment from its customers.
• The factor: This is the financial institution or company that purchases your invoices and provides you with immediate cash.

How accounts receivable factoring work: A simple 6-step process

Accounts receivable factoring simplifies your cash flow by converting your invoices into immediate funds. Here's a typical 6-step process:

Step 1: Provide goods or services to your customer

The factoring process begins when you deliver goods or services to your customer and subsequently issue an invoice for payment. This invoice represents the accounts receivable that you will eventually sell to the factor.

Step 2: Submit your invoices to the factor

Once your customer receives the invoice, you submit it to the factoring company. This usually involves providing details about the invoice value, the customer, and the payment terms. The factor then verifies the legitimacy of the invoice and the creditworthiness of your customer.

Step 3: Receive an advance from the factor

After approving your invoice, the factor provides you with an immediate cash advance, typically ranging from 70% to 90% of the invoice's total value. This advance is critical for addressing your immediate working capital needs.

Step 4: The factor collects payment from your customer

The factor takes responsibility for collecting the full payment from your customer on the invoice's due date. In "notification factoring," your customer is aware that they are paying the factor directly. In "non-notification factoring," your customer continues to pay you, and you then forward the payment to the factor.

Step 5: The factor remits the remaining balance

Once the factor receives the full payment from your customer, they remit the remaining balance of the invoice to you. This balance is the original invoice amount minus the initial advance and the factor's fees.

Step 6: The factoring relationship continues

This process is typically ongoing. As you generate new invoices, you can continue to submit them to the factor for immediate cash flow, establishing a consistent and predictable funding source for your business.

Why do businesses turn to receivables factoring?

Businesses often turn to accounts receivable factoring for several key reasons, primarily driven by the need for immediate liquidity and efficient financial management. Here's why it's a valuable option for many companies:

To manage rapid growth when sales outpace cash on hand

Fast-growing businesses often face a paradox: increasing sales can strain cash flow because more capital is tied up in accounts receivable.

Factoring provides immediate access to funds, allowing these businesses to purchase more inventory, invest in marketing, or hire additional staff to support their expansion without waiting for customer payments.

To cover payroll and operational expenses during seasonal lulls

Many industries experience seasonal fluctuations, leading to periods of reduced revenue. Factoring can bridge these gaps by converting outstanding invoices into cash, ensuring that businesses can meet their payroll obligations, cover rent, and maintain operations even when sales are slow.

To overcome the challenge of having large clients with long payment terms (net 60/90)

Dealing with large clients often means accepting longer payment terms, such as net 60 or 90 days. While these clients can be lucrative, their extended payment cycles can severely restrict a business's working capital.

Factoring allows businesses to access the cash from these invoices immediately, improving liquidity and reducing reliance on lengthy payment terms.

When unable to qualify for traditional bank loans due to credit history or time in business

Startups or businesses with less-than-perfect credit histories often struggle to secure traditional bank loans. Factoring focuses on the creditworthiness of the customer's invoices rather than the business's own credit, making it an accessible funding option for companies that may not qualify for conventional financing.

To reduce the administrative burden of chasing payments

Managing accounts receivable can be time-consuming and resource-intensive. When a factor purchases invoices, they often assume responsibility for collections, freeing up the business's staff to focus on core operations, sales, and customer service.

This reduces administrative overhead and allows more efficient use of internal resources.

Benefits of factoring receivables

Factoring provides businesses with immediate access to cash flow, primarily to offer strategic, financial, and operational insights by optimizing working capital and reducing the wait time for customer payments.

The primary benefits of factoring receivables include:

Immediate access to cash

Factoring provides immediate liquidity by converting outstanding invoices into cash, which can be used to cover operational expenses, invest in growth, or seize new opportunities. This rapid access to funds helps businesses maintain healthy cash flow without waiting for customer payments.

Reduced credit risk and collections burden

In many factoring arrangements (especially "non-recourse factoring"), the factor assumes the risk of customer non-payment. This protects your business from bad debt and frees up your team from the time-consuming and often difficult task of chasing overdue payments, allowing them to focus on core business activities.

No debt incurred

Unlike traditional loans, factoring is the sale of an asset (your invoices) rather than a debt. This means it doesn't appear as debt on your balance sheet, preserving your borrowing capacity for other needs and potentially improving your debt-to-equity ratio.

Flexible funding that scales with your business

Factoring facilities are often highly flexible and can increase or decrease based on your sales volume. As your sales grow, so does the amount of funding available through factoring, making it a scalable solution that adapts to your business's changing needs.

Improved financial ratios

By converting accounts receivable into cash, factoring can improve key financial ratios, such as the current ratio and working capital ratio. This can make your business more attractive to potential investors or lenders in the future.

Factoring vs. receivables financing: What's the difference?

While often used interchangeably, accounts receivable factoring and accounts receivable financing (also known as invoice financing or invoice discounting) are distinct financial solutions.

The key difference lies in who controls the sales ledger and who collects the payments. 

Accounts receivable factoring

In factoring, you sell your invoices to a factor at a discount.

• Ownership transfer: The factor takes ownership of your invoices.
  
  
• Collection responsibility: The factor is responsible for collecting payments directly from your customers. This means your customers will typically be aware that a third party is involved in their payment process.
  
  
• Administrative burden: The factor assumes the administrative burden of collections, freeing up your internal resources.
  
  
• Balance sheet impact: It's often treated as a sale of an asset rather than a loan, so it typically doesn't add debt to your balance sheet.
  
  
• Credit risk: Depending on the agreement (recourse vs. non-recourse), the factor may or may not assume the credit risk of your customers not paying.

Accounts receivable financing (invoice financing/discounting)

In receivables financing, you borrow money against your invoices as collateral.

• Ownership retention: You retain ownership of your invoices.
  
  
• Collection responsibility: You remain responsible for collecting payments from your customers. Your customers typically won't know that your invoices are being used as collateral.
  
  
• Administrative burden: You maintain the administrative burden of managing your sales ledger and collections.
  
  
• Balance sheet impact: It's treated as a loan, appearing as debt on your balance sheet.
  
  
• Credit risk: You retain the credit risk of your customers not paying.

Choosing between factoring and financing depends on your business's specific needs, desire for control over collections, comfort with debt on the balance sheet, and willingness to outsource administrative tasks.

Types of accounts receivable factoring

The two primary forms are recourse factoring and non-recourse factoring. The choice between them largely depends on your business's risk tolerance, the creditworthiness of your customers, and your budget.

Recourse factoring

In recourse factoring, your business remains liable for unpaid invoices. This means that if your customer fails to pay the factor, you are obligated to buy back the invoice or replace it with another.

• Cost: Generally cheaper than non-recourse factoring due to the lower risk assumed by the factor.
  
  
• Risk: Your business retains your customers' credit risk.
  
  
• Best for: Businesses with a strong understanding of their customers' creditworthiness and a history of reliable payments. It's suitable when you are confident in your customers' ability to pay their invoices.

Non-recourse factoring

With non-recourse factoring, the factor assumes the risk of non-payment by your customer (with some exceptions, such as disputes over goods or services). This means if your customer defaults on a legitimate invoice, the factor bears the financial loss.

• Cost: More expensive than recourse factoring because the factor takes on greater risk.
  
  
• Risk: The factor assumes the credit risk of your customers, offering your business greater protection against bad debt.
  
  
• Best for: Businesses working with new or less-established customers, or those in industries where payment reliability can be a concern. It's also beneficial for companies that want to offload the credit risk entirely.

Choosing between recourse and non-recourse factoring involves weighing the cost savings against the level of risk you are willing to retain.

How to calculate factoring costs

Calculating accounts receivable factoring involves understanding the fees charged by the factor and the advance rate. Here’s a breakdown of the key components and how to calculate the net proceeds you'll receive:

Key terms to understand

• Invoice value: The total amount of the invoice you are selling to the factor.
  
  
• Advance rate: The percentage of the invoice value the factor pays you upfront. This typically ranges from 70% to 90%.
  
  
• Factoring fee (Discount rate): The fee charged by the factor for their service. This is usually a percentage of bill value, often calculated weekly or monthly.
  
  
• Reserve: The portion of the invoice value (the difference between the invoice value and the advance) that the factor holds back until the customer pays.

The calculation process

The calculation generally involves two main steps: determining the initial advance and then calculating the final settlement after the fee is deducted.

Step 1: Calculate the initial advance

The initial advance is the immediate cash you receive after selling the invoice.

Formula:
Initial Advance = Invoice Value × Advance Rate

Example:

If you have an invoice for £10,000 and the factor offers an 85% advance rate:
Initial Advance = £10,000 × 0.85 = £8,500

Step 2: Calculate the factoring fee

The factoring fee is typically calculated based on how long it takes for your customer to pay the invoice. Factors often charge a percentage per week or per month.

Formula (Example for weekly fee):
Factoring Fee = (Invoice Value × Weekly Fee Rate) × Number of Weeks Until Payment

Example:

Let's assume the factor charges a 1% weekly fee. If your customer pays the £10,000 invoice in 3 weeks:
Factoring Fee = (£10,000 × 0.01) × 3 = £100 × 3 = £300

Step 3: Calculate the net proceeds

The net proceeds are the total amount you receive from the factor, which is the full invoice value minus the factoring fees. This is typically paid in two parts: the initial advance and the remaining reserve once the customer pays, less the fees.

Formula:
Net Proceeds = Invoice Value - Factoring Fee

Example:

Formula:
Net Proceeds = Invoice Value - Factoring Fee

Using the previous examples:
Net Proceeds = £10,000 - £300 = £9,700

The final payment you receive from the factor (after your customer pays) will be the reserve amount minus the factoring fee.

Formula for final payment from factor:
Final Payment = (Invoice Value - Initial Advance) - Factoring Fee (if not already deducted from reserve)

More simply, it's the Net Proceeds minus the Initial Advance you already received.

Example of final payment:

Final Payment = £9,700 (Net Proceeds) - £8,500 (Initial Advance) = £1,200

This £1,200 represents the remaining portion of your invoice after the initial advance and the factoring fee have been accounted for.

Accounts receivable factoring example

Let's put it all together with a hypothetical scenario:

• Invoice value: £50,000
• Advance rate: 80%
• Factoring fee: 0.75% per week
• Customer payment term: 45 days (approximately 6.4 weeks, let's round to 7 weeks for calculation purposes)

1. Initial advance:
   £50,000 × 0.80 = £40,000
   
   
2. Factoring fee:
   (£50,000 × 0.0075) × 7 weeks = £375 × 7 = £2,625
   
   
3. Net proceeds (Total received over time):
   £50,000 - £2,625 = £47,375
   
   
4. Final payment (After customer pays):
   £47,375 (Net Proceeds) - £40,000 (Initial Advance) = £7,375

So, in this scenario, you would receive £40,000 upfront, and then an additional £7,375 once your customer pays the factor, totaling £47,375 for the £50,000 invoice.

How much does accounts receivable factoring cost?

The cost of factoring primarily depends on factors such as the volume of invoices, customer creditworthiness, industry, and specific terms. 

Key cost components include a discount rate (factoring fee) ranging from 0.75% to 3% per month or 0.25% to 1% per week, along with potential application/setup, service, wire transfer, late payment, and non-notification fees. 

The cost is lower for financially stable customers and higher volumes of invoices. Non-recourse factoring (where the factor assumes credit risk) is generally more expensive than recourse factoring. Longer customer payment terms also lead to higher fees. 

For example, a £50,000 invoice paid in 7 weeks with a 0.75% weekly factoring fee could cost £2,625, representing 5.25% of the invoice value. Understanding these cost components is crucial for comparing providers and choosing the most cost-effective solution.

Factoring vs. the alternatives: A head-to-head comparison

Which industries are good (and bad) fits for factoring?

Accounts receivable factoring isn't a one-size-fits-all solution. Its effectiveness often depends on the industry your business operates within and the typical payment cycles and client relationships common in that sector.

Good fit industries

Factoring is particularly well-suited for industries with long payment terms, high volume, or where large invoices are common. In these sectors, it's often a common and understood financial practice:

• Trucking and transportation: Carriers often face immediate fuel and payroll costs but wait 30-60 days for freight payments. Factoring provides the quick cash needed to keep trucks on the road.
  
  
• Staffing agencies: Staffing firms pay their temporary workers weekly or bi-weekly but may not receive payment from clients for 30-90 days. Factoring bridges this payroll gap.
  
  
• Manufacturing: Manufacturers often incur significant upfront costs for raw materials and production, with sales terms extending for months. Factoring helps maintain working capital to fulfill new orders.
  
  
• Wholesale and distribution: Businesses in this sector often deal with large order volumes and extended payment terms from retailers. Factoring ensures a steady flow of funds to purchase inventory and manage operations.

Potential red flag industries

While factoring can be beneficial, it's less ideal or even problematic for certain industries due to their revenue models or unique operational challenges:

• SaaS (Software as a Service): SaaS companies typically operate on recurring revenue models (monthly or annual subscriptions). Factoring is designed for one-time or project-based invoices, not recurring subscription payments.
  
  
• Construction: The construction industry often involves complex billing, progress payments, change orders, and potential disputes that can make factoring challenging and less straightforward.
  
  
• Professional services (e.g., legal, consulting): These businesses often rely heavily on strong, trust-based client relationships. Involving a third-party factor in the collection process can sometimes complicate these sensitive relationships, especially if clients prefer direct communication with the service provider.

Accounts receivable factoring impact on business

Accounts receivable factoring provides immediate cash flow but has long-term implications. Key considerations include:

Profit margin impact

Factoring fees directly reduce net profit. Consistent reliance on factoring can significantly diminish overall profitability over time, requiring a careful evaluation of whether the cost of immediate liquidity outweighs the reduction in profit margins.

Future lending ability

Traditional banks may view consistent factoring with caution, interpreting it as a sign of cash flow challenges or weak credit management. This can make it harder to secure traditional loans at favorable rates in the future.

Customer perception

In notification factoring, customers become aware of a third-party factor, which could lead them to perceive the business as financially unstable. While common in some industries, it's crucial to assess if this perception might damage customer relationships or brand image, emphasizing the importance of clear communication.

Should you use factoring? Your decision making checklist

Once you've considered whether your industry is a good fit, evaluate your specific business situation with the following checklist. If you answer "yes" to several of these questions, accounts receivable factoring could be a strategic financial solution for you:

• My business is growing faster than my cash flow. Are increasing sales straining your working capital because money is tied up in unpaid invoices?
  
  
• My customers are creditworthy but consistently pay late. Do you have reliable clients, but their extended payment terms (net 60, net 90) create cash flow gaps?
  
  
• I have been unable to secure a traditional bank loan. Has your business been denied conventional financing due to a short operating history, insufficient collateral, or a less-than-perfect credit score?
  
  
• I spend too much time on collections instead of core business activities. Is your team bogged down chasing overdue payments, diverting resources from sales, operations, or customer service?
  
  
• I need immediate access to working capital without taking debt. Are you looking for a funding solution that doesn't add liabilities to your balance sheet?
  
  
• I want to reduce my credit risk and protect against bad debt. Would you benefit from a solution where a third party assumes the risk of your customers defaulting on payments (non-recourse factoring)?
  
  
• My business experiences seasonal fluctuations in revenue. Do you need a way to bridge cash flow gaps during slower periods to cover ongoing expenses like payroll and rent?
  
  
• I want a flexible funding source that scales with my sales. Do you need a financing option that can quickly increase or decrease based on your invoice volume?

How to choose the right accounts receivable factoring company: 5 tips

Choosing the right accounts receivable factoring company is a critical decision that can significantly impact your business's financial health and operational efficiency. 

It's not just about finding the lowest fee; it's about partnering with a reliable provider that understands your industry, offers transparent terms, and aligns with your long-term goals.

Here are five essential tips to guide your selection process:

1. Understand their fee structure

Factoring fees can be complex, often involving more than just a simple discount rate. A reputable factoring company will be transparent about all potential costs.

• "What are ALL of your fees (discount, service, application, etc.)?"
• "Are there any hidden charges or penalties?"
• "How are fees calculated (e.g., daily, weekly, monthly, tiered)?"
  
  

2. Assess their customer service and communication

Since the factor will be interacting with your customers, their approach to collections and communication is paramount. You want a partner who represents your business professionally and efficiently.

• "What is your process for contacting my customers?"
• "How do you handle disputes or discrepancies with invoices?"
• "What communication channels do you use, and how often will I receive updates?"
  
  

3. Evaluate contract terms and flexibility

Factoring agreements can vary widely in length and flexibility. Avoid companies that lock you into long, rigid contracts, especially if your business needs may change.

• "What are the contract length and termination requirements?"
• "Are there minimum volume requirements?"
• "Can the advance rate or fee structure be renegotiated as my business grows?"
  
  

4. Check industry experience and reputation

A factor with experience in your specific industry will better understand your business's unique challenges, payment cycles, and customer base. Their reputation also speaks to their reliability and ethical practices.

• "Can you provide references from clients in my industry?"
• "How long have you been in business, and what is your track record?"
• "Are you a member of any industry associations?"
  
  

5. Consider their technological capabilities

Modern factoring companies leverage technology to streamline the application, submission, and reporting processes. Efficient online platforms can save you time and provide clear insights into your accounts.

• "Do you offer an online portal for invoice submission and tracking?"
• "What kind of reporting and analytics do you provide?"
• "How secure is your data management system?"

By thoroughly vetting potential factoring partners using these tips and questions, you can select a company that not only provides the necessary cash flow but also acts as a valuable extension of your financial operations.

Conclusion

Accounts receivable factoring turns unpaid invoices into immediate cash, boosting working capital and financial agility. This method improves liquidity, reduces debt reliance, and streamlines cash flow, letting businesses focus on core operations.

Success hinges on understanding the process, costs, and choosing a reliable factoring partner for long-term financial health.

Ready to accelerate cash flow without damaging client relationships? Discover how Chaser automated credit control solutions can reduce late payments, so you may not need factoring at all. 

Book a demo today.
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