AR Factoring Vs. Borrowing

by Justin Johnson

Accounts receivable factoring is the process of selling a company's accounts receivable assets in exchange for cash. A "factor," in this case, is an institution that offers such services to companies, as traditional lending institutions typically don't do. Factoring has advantages and disadvantages that small-business owners should take into account before deciding to factor receivables, including cost and access to capital, as well as the impact the process will have on the company's financial statements.

Increased Cost of Capital

Factoring is an expensive method for small businesses to use to generate cash flow. Cost of capital refers to the charge incurred when a company borrows funds; a factoring company will charge a fee of up to 20 percent of the receivable balance to cover the cost of the factoring transaction because the factor is taking on the risk of the uncollected receivable asset. By contrast, the weighted average interest rate of a traditional commercial or industrial loan was 2.28 percent between Feb. 4 and Feb. 8, 2013, according to a Federal Reserve survey of lenders.

Increased Access to Capital

Factoring provides businesses in poor economic or credit situations an opportunity to gain access to vital business capital faster than the regular collection of their accounts receivable could have provided. This is important for many businesses that have found it harder to gain access to credit in the wake of the recession that began in 2007. According to the Federal Reserve Bank of Chicago, access to traditional business capital by small businesses during the recent recession decreased by more than 50 percent.

Favorable Balance Sheet Affect

Accounts receivable factoring's affect on a company's balance sheet relates to the conversion of one type of asset to another type of asset. When the accounts receivable are sold to the factor, the asset that was classified as a receivable becomes classified as cash, generated from an addition to the sales revenue account. Traditional borrowing, on the other hand, places a liability on the balance sheet in addition to the increase in cash obtained from the loan. Typically, the factor will hold a small reserve until it has received payment in full for the receivables purchased from the seller. If a reserve is included in the sale, the seller should include the reserve as an asset on the balance sheet.

Potential for Decreased Financial Risk

The costs and risks associated with delinquent customer accounts contribute to the rising usage of factoring. While the company pays a higher rate for its capital, it decreases its exposure to delinquent customer accounts. Traditional borrowing places pressure on the sales revenue of a company, as more revenue is redirected from operating activities to financing activities.

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