Asset Based Lending vs. Factoring
by Kevin O'Hare, SVP / ABL Division Group Manager, Scott Valley Bank
As asset-based lenders (ABL), we are frequently asked to explain the differences between our primary product, Accounts Receivable financing (often referred to as A/R financing) and Factoring. While they have similar qualities, the two financing solutions vary in many areas. It is important to be aware of how these two financing options differ so that you can make the proper decision should you ever seek to accelerate your operating capital by utilizing one these popular forms of financing.
In the United States alone, Accounts Receivable financing represents a $600+ billion industry, while Factoring is a $100+ billion dollar industry. The main difference is that A/R financing allows the borrower to leverage all of their A/R in order to provide the working capital necessary to supplement the dips and valleys in their cash flow. Factoring, on the other hand, involves the sale of specific invoices owed by the client’s customer – the account debtor - to the Factoring Company. With the Factoring method, the client can pick and choose which invoices they’d like to finance and the Factor can determine how much, if any, they’re willing to purchase against the invoice(s) offered for sale.
An advantage of A/R financing is that you can judiciously manage your cash flow by borrowing only the amount of your cash deficit. In fact, each business day you can borrow only what is needed for that day. This matches your loan balance with your negative cash position for that exact time frame, thereby enabling you to reduce your interest charge as you borrow only what is necessary – a very utilitarian system. Most Factoring situations require you to sell the full amount of your invoice, so you may have to incur more charges by obtaining more money than you actually need.
A/R financing more closely parallels bank-oriented credit facilities in that the financing is structured as a loan and not as a sale, making the parties known as the lender and the borrower. Since the lender looks at the strength of the financial condition of the borrower as well as the borrower’s customer base, it is harder to qualify for compared to Factoring. However, because of this, the risk is typically less, especially if the borrower has a diversified customer base and is operating profitably. All of which renders this revolving style of working capital financing a much less expensive option than Factoring.
Another attractive feature is that Accounts Receivable financing largely replicates the pricing model of conventional bank financing, as the finance fees are charged on the average daily loan balance and not on the face amount of the invoices. This method of calculating the fees is inherently less expensive than most Factoring arrangements. Also, because all of the accounts receivable are pledged as a borrowing base, the collateral monitoring may not be as invasive or exhaustive as with Factoring. Moreover, with A/R financing, the full amount of the borrower’s Accounts Receivable collections are applied daily to the loan, so the loan balance is driven to its lowest possible level. This in turn minimizes the borrowing cost.
Unlike A/R financing, the primary underwriting and credit decisions in Factoring are largely focused upon the strength of the client’s customers, with a very limited review of the client’s own financial condition. Often times, this makes it easier to qualify for, especially so if the client is selling to Fortune 500 type customers. In general, this style of financing is likely higher on the risk curve since the financial statements of the client may not add much strength to the deal. As a result of this lack of (or limited) outside support or secondary sources of repayment, the Factor may need to conduct a thorough review of the accounts receivable, including contacting the account debtor to verify the validity of the obligation. This hands-on monitoring can be laborious for the Factor. Therefore, due to the perceived increased risk coupled with the additional expense of managing the A/R, Factoring is the more expensive of the two options.
In addition, since the Factoring Company actually purchases the invoice(s) instead of lending the money to the client, they may need to inform the client’s customer (vendor or account debtor) to have the check remittance made payable directly to the Factoring Company. This is known as direct notification and, depending on how it is handled, may give rise to business viability questions by the account debtor.
In both A/R financing and Factoring, a certain dollar percentage is advanced against the A/R. So, when the invoice is ultimately paid by the account debtor, it leaves the non-advanced portion remaining for the borrower/client. This is sometimes called the reserve. With the A/R financing method, the full amount of the collection is applied daily to the loan including this residual amount, the latter of which is made available to the borrower. However, if the borrower doesn’t need that money right away, it lowers their loan balance thereby reducing their interest charge. On the other hand, if it is required for cash-flow purposes it can be obtained, provided the loan is in compliance with the borrowing formula. This adds a degree of flexibility, unlike a typical Factoring transaction where the proceeds may be held in a reserve account until a future settlement date. Subsequently, this Factoring cash application method may present a real disadvantage for a cash-strapped entity.
The usual financing progression would be for a start-up company to rely on Factoring first, as they would characteristically possess a smaller pool of A/R or a highly concentrated customer base, before eventually graduating to A/R financing and other forms of asset-based lending. There are many more nuances between these various sources of working capital financing; however, this summarizes the main distinction between the two. A/R financing and Factoring are both designed to support a company’s growth and provide a nimble vehicle by which to accelerate their cash flow in order to enhance revenue generating opportunities. If you are interesting in learning more about these or other Asset-Based Lending products please don’t hesitate to contact me.