How to Qualify and Account for Accounts Receivable Factoring

Accounts receivable factoring is a business financing strategy. It can be used to fund growth by acquisitions, buy new inventory or supplies, launch a marketing initiative, or to pay employees. Although bank loans or credit lines are similar, they differ in two key respects: The qualification process and the means of accounting for the factoring funds are different.
Qualifying for Factoring

In order to meet the invoice factoring qualifications, your company needs to have accounts receivables that are unencumbered, meaning no one else can have a primary lien or claim to the invoice payments when they come in. This requirement can cause a problem for some industries, such as construction companies.

Secondly, your customers must have a history of paying their invoices on time. Unlike a bank, a factoring company analyzes the credit of your customer, not your business. Normally, the factoring company will ask for an accounts receivable aging report to examine if and when the customers typically pay. This evaluation affects not only your ability to qualify, but can also influence your fee structure. Some factors may classify your accounts into different baskets and charge lower fees on faster paying customers and higher fees on slower paying customers.

Many factoring companies will have a representative meet with you in person and review your company’s financial situation. The representative may examine your company’s financial statements, your accounts receivables, and your payables aging reports. The factoring company will also ask for information on your customers so that your receivables can be confirmed.

Once the factoring company has evaluated your situation, make a proposal. This will overview the financing terms, including the maximum loan limit, advance rate, and discount fee schedule. It will also detail the provisions for charging back or selling back the unpaid invoices and any added fees or liens. The proposal will also explain how your customers will be notified of the sale of the invoices, and what kind of financial reports will be provided to you by the factor.

Accounting for Factoring

When you receive a bank loan, you might use your accounts receivables or some other business asset as collateral, but you still retain ownership of the assets. With factoring, you actually sell the invoices to the factoring company and they are treated like the sale of any other business asset. The factored accounts are removed from your receivables and the fair value of any assets received or liabilities accepted in exchange are acknowledged. The difference is recorded as a gain or loss in your books.

Basically, the transaction is considered off balance sheet” financing, as it just decreases your accounts receivables by the same dollar amount that it increases cash in the bank. In contrast, a bank loan shows up as a liability and creates a monthly interest expense. With factoring you reduce the debt on your balance sheet, which lowers your debt to equity ratio.

As you can see, factoring has its advantages, particularly if your business is unable to qualify for a bank loan, a line of credit, and/or you need to reduce your debt load and debt to equity ratio. In fact, keeping some of your financing off your books may allow your company to utilize both traditional bank loans and factoring finance as dual components of your financing strategy, especially when you are in a high-growth mode.

For more specific information on how factoring can help your business, contact us.