Invoice factoring is when you sell your accounts receivables or invoices to another company at a discount in exchange for immediate cash. You’ll receive part of the payments right away and your customers will pay the invoice factoring company directly. Factoring can help you improve working capital and cover emergency expenses quickly, without the hassle.
There are two types of factoring: recourse factoring and non-recourse factoring. Although both options can improve your cash flow, it’s a good idea to understand how they differ so you can make the best decision for your small business and unique needs.
Recourse factoring is the most common type of factoring. If you go this route, it will be your responsibility to cover the cost of invoices that your customers do not pay for any reason. In other words, you bear all the credit risk.
It’s a good option if you have strong balance sheets and reliable clients who tend to pay on time. Recourse financing may also make sense if you’d like the most cost-effective factoring method that will allow you to sell your invoices at the lowest rates. It’s ideal if you’re a stable operation, have a solid plan for cash flow, and are confident in your customer’s ability to pay.
Pros and Cons of Recourse Factoring
The most noteworthy benefits and drawbacks of recourse factoring include:
- Easy to qualify for: Since you’ll be on the hook for any unpaid invoices, the factoring company won’t have to take on the risk of non-payment. Therefore, you’ll be able to secure funding, regardless of your credit rating.
- Affordable: Compared to non-recourse factoring, recourse factoring comes with lower fees. While you may take on more risk if you choose this method, you will save money in the process.
- Risky: With recourse factoring, you put your business income at risk. If a customer becomes insolvent, you’ll have to pay their invoice on your own or give the factoring company an invoice that’s worth the same amount.
- Potential for significant debt: If you end up with many unpaid factored invoices, you’ll have to find a way to cover them. This can steer you into a cycle of debt, which may be tough to get out of.
Non-recourse factoring is when your factoring company cannot take recourse if your customers don’t pay. Put simply, they have to accept the loss for any unpaid invoices. It’s important to note that while factoring arrangements vary, non-recourse doesn’t usually cover all situations.
For example, if non-payment is the result of your negligence or fraud, you would still be responsible for the unpaid invoices. Non-recourse factoring might be a smart choice if you have risky clients that often pay late or fail to pay at all.
Pros and Cons of Non-Recourse Factoring
The greatest advantages and disadvantages of non-recourse factoring are as follows:
- No risk: You can think of non-recourse factoring as credit insurance. All liabilities of unpaid invoices will be transferred to the factoring company and you’ll receive access to your money on time without any risk.
- Improved cash flow: Non-recourse factoring leads to steady cash flow, even when you have to wait for payments or have customers who are unable to pay your invoices. This can make it easier for you to cover operational costs and invest in business growth.
- More expensive: While non-recourse factoring allows you to solve your cash flow issues without any credit risk, you’ll have to accept a higher factoring rate. It’s more expensive than recourse factoring.
- Can be difficult to find: As a result of its greater risk, non-recourse factoring is less common than recourse factoring. This means you might have to shop around and do some research to locate lenders that offer it.
Key Differences Between Recourse Factoring and Non-Recourse Factoring
There are three major differences between recourse factoring and non-recourse factoring including:
Compared to non-recourse factoring, recourse factoring has lenient requirements. This is due to the fact that the invoices will always get paid, either by you, the borrower or your customers. Non-recourse factoring puts all the risk on the factoring company so it’s usually harder to qualify for. You can also expect the approval and funding process to take more time than it would with recourse factoring.
If you opt for recourse factoring and an invoice remains unpaid after a certain amount of time, the invoice is returned to you. It’s your responsibility to somehow resolve the bad debt. With non-recourse factoring, on the other hand, the factoring company must deal with debt from unpaid invoices.
Cost of Factoring
Since recourse factoring makes you liable for unpaid invoices, it’s less expensive. On the flipside, non-recourse factoring is the higher cost option because the risk of unpaid invoices goes to the factoring company and they need to be compensated for it.
Recourse Factoring vs. Non-Recourse Factoring: Which Option is Better?
The best type of factoring depends on your particular business and circumstances as each method has its own set of pros and cons. To determine the ideal method, ask yourself the following questions.
- Do your customers pay their bills on time? If the answer is “yes”, recourse factoring is likely the way to go because there is little risk of your customers not paying the factoring company back. In this situation, you’d probably save money.
- Do your customers fail to pay on a regular basis? If your customers tend to default on payments, there’s a good chance they won’t pay the factoring company either. Non-recourse factoring is a better choice because you won’t be responsible for any unpaid invoices.
- How well do you handle uncertainty? If you know you’ll worry about whether or not your customers will repay the factoring company, non-recourse factoring will give you greater peace of mind. You’ll know that once an invoice is sold to the company, they’ll be out of your hands, even if a customer fails to pay.
The two major types of invoice factoring for business owners include recourse factoring and non-recourse factoring. While recourse factoring is more affordable, it’s only beneficial if you have creditworthy customers with a track record of on-time payments. Non-recourse factoring is a better option if your customers have compromised payment histories and you don’t want to be responsible for their missed payments.
The higher fees of non-recourse factoring may be worth the protection you’ll receive. Once you consider the creditworthiness and behaviors of your customers as well as your risk tolerance, you’ll be able to choose the best type of invoicing for your needs. When you’ve made a decision and are ready to apply, reach out to us here at Cultiva Financial.