The following is a guest post about AR Factoring from Curt Matsen, CPA.  Curt is the Author of the Accounts Receivable Factoring Guide, a comprehensive guide that helps entrepreneurs accelerate cash flow to secure capital to fund business growth.

Every entrepreneur and business faces cash shortage at some point in their life cycle, especially when the economy is bleak, credit is tight and banks are simply not lending.

So what’s a man to do to secure the capital needed to grow and expand the business? The answer is simple – factor the invoices!

What is AR Factoring?

Factoring in its simplest sense means selling tomorrow’s promise for today’s price.  Every business has a customer or client, and every business sells something, whether a product or service to their customers and clients.

Often times, a business provides the goods and services and bills the customer, and the customer is not required to pay the invoice until X days out.  It is the same concept of selling on credit, or using a credit card to make payments for that matter.

The payment owed to the business is a receivable from the customer or client. When a business “factors” the receivable, it is essentially giving up the rights to collect on the payment in exchange for a payment today.

Yes, there are companies in business who specifically look for receivables to purchase.  What’s in it for them? These companies charge a set up fee, plus a commission, often referred to as the discount rate, on the invoice or receivable.

For example, if you had a business and customer A owed you $100 bucks 30 days out from today, you might consider selling, or factoring that receivable to a factoring company, also called a Factor, for a smaller amount today.

In this example, if the Factor charged you a $2 set up fee and a 3% discount rate, you would get $95 from the Factor ($100 minus 3% fee minus $2 set up fee).  The Factor then will collect the full $100 from your customer or client 30 days out when the invoice is due for payment.

Why AR Factor?

There are several reasons why an entrepreneur may decide to factor invoices.  The three most common are to secure working capital, secure growth capital and to remove risk from doing business.

Let’s say rent is coming up due soon and the entrepreneur doesn’t have the cash flow currently but has a significant amount of receivables, he or she may decide to factor them in order to raise the working capital needed to pay the rent.

The same entrepreneur may also want to grow the business by buying more product to sell, but with receivables on the books, all their cash may be tied up and hence they cannot make the purchases they need to grow.  An entrepreneur can sell the receivables and raise growth capital to fund expansion.

Finally, what happens when the customer or client does not pay as promised?  To remove this risk, an entrepreneur may decide to factor the receivable and collect cash today. Heck with the customer if they don’t come through right?

Though this may work in some cases, it does not in others. Many factoring companies will buy receivables “with recourse”, which means that if the customer defaults, the business who sells them the receivable is on the hook to pay the obligation. It can be a tough world sometimes.

Does AR Factoring Apply to Joe & Jane?

Of course it does.  Whether one is a large scale business operation or a small scale entrepreneur, anyone can benefit from receivable or invoice factoring.

For example, if you are a blogger or a website owner and you have advertisement contracts with two large companies that pay you $500 per month for 12 months each. You can take your contracts to the market and see if you can get someone to pay you upfront for all 12 months.

Obviously that example is overly simplistic. Furthermore, internet entrepreneurship is still relatively in its infancy, therefore the market for this type of factoring may not exist. However, you get the point.

Here is a more realistic example.  Let’s say that you were awarded a structured settlement judgment from a lawsuit, you have the option of factoring your settlement and receiving a lump sum payment today rather than collecting a small fraction of it every month.

AR Factoring Concluding Thoughts

There are more financial products in the US than there are farms in Asia, but not all the financial products are well known to all. Factoring is one such example.  However, knowing what factoring is and how you can use it to your advantage can give you the competitive edge you need.

I hope you found this article helpful.  Even if you can’t make practical use of this information, I hope you will be able to assist someone who might be able to use it.  Knowledge is power and one can never be too knowledgeable.   I’d be happy to answer any questions and address your concerns in the comments below, or at any time on my personal website.

Crystal’s Comments:  Thanks so much for teaching me something new!  This helps explains all of those commercials about selling your rights to long-term payouts for a lump sum payment now – except these businesses can get much better returns than the people in those commercials, lol.