Factoring: De-Risking Trade Credit in B2B Finance

Factoring is a financial transaction in which a company sells its accounts receivable (invoices) to a third party (a factor) in exchange for immediate cash. In practice, the seller (supplier) submits unpaid invoices to the factor, which advances most of the invoice value (often 70–90%) shortly after invoice issuance. The factor then collects payment from the buyer (customer) over time. By treating receivables as assets to be sold rather than loans, factoring provides working capital without adding debt. In effect, factoring is a form of trade finance that converts outstanding sales into cash, allowing businesses to bridge cash-flow gaps without waiting 30–90 days for payment.

Importantly, factoring shifts some or all of the credit risk on the receivables. The factor essentially steps into the seller’s shoes: it assumes the duty of collecting payment from the buyer and may absorb losses if the buyer defaults (depending on the factoring arrangement). As the seller’s invoices are sold at a discount, factoring can improve liquidity and streamline collections, letting companies focus on growth instead of chasing overdue payments. In short, factoring is a tool that helps companies “get paid now” for credit sales, while offloading collection and payment risk onto a specialized finance partner.

How Factoring Works: Seller, Buyer, and Factor Roles

Factoring involves three parties: the seller (the company selling goods/services on credit), the buyer (the debtor who owes payment), and the factor (the finance company buying the receivable). The typical process is:

Seller Issues Invoice: The seller delivers goods or services and issues an invoice to the buyer under normal trade-credit terms.
Seller Sells the Invoice: The seller “factors” that invoice by assigning or selling it to the factor. This is usually done under a factoring agreement.
Advance Funding: The factor verifies the invoice and the buyer’s credit. If approved, the factor pays the seller an immediate advance, often around 70–90% of the invoice amount. The remaining balance (the “reserve”) is held by the factor.
Collection: The factor then collects payment from the buyer when the invoice becomes due. (In a disclosed factoring arrangement, the buyer is notified and pays the factor directly; in confidential (non-notification) arrangements, the seller may continue to collect on behalf of the factor.)
Reserve Settlement: Once the buyer pays, the factor releases the reserved balance to the seller, minus factoring fees and charges.

Throughout this process, the seller essentially treats its receivables as cash: it no longer has to wait for the buyer’s payment to fund operations. The factor, for its part, assumes responsibility for collections. (Under U.S. law, the factor typically perfects its ownership by filing a UCC-1 financing statement. The buyer’s role remains largely the same – it pays its invoices on the original terms, except now payment is directed to the factor instead of the seller once notified.

Factors typically require an application and due diligence. They will review both the seller’s business and, more importantly, the creditworthiness of the buyer. Since the factor is buying the buyer’s debt, factors focus on whether the buyer is likely to pay. Thus, the factor may conduct credit checks on the buyer and set credit limits or holdbacks based on that analysis. If the factor is confident the buyer will pay, it will fund the receivable immediately.

Recourse vs. Non-Recourse Factoring

A key distinction in factoring arrangements is recourse versus non-recourse factoring. This defines who ultimately bears the credit risk if the buyer fails to pay:

Recourse Factoring: The seller retains the risk of non-payment. If the buyer defaults or goes bankrupt, the factor has the right to recall the funds from the seller or force the seller to repurchase the unpaid invoice. In practice, this means that while the seller gets cash quickly, it must indemnify the factor if collection fails. Recourse agreements are most common and generally carry lower fees and higher advance rates, but the seller remains on the hook for bad debts. Essentially, the seller is “on risk” – the factor can demand payment from the seller if the buyer doesn’t pay.
Non-Recourse Factoring: The factor assumes the credit risk for specified reasons of non-payment. In a true non-recourse arrangement, if a buyer fails to pay (typically due to bankruptcy or insolvency), the factor cannot demand repayment from the seller. In this case, the factor absorbs the loss. Because of the higher risk, non-recourse factoring usually commands higher fees and may cover only approved (well-rated) buyers. The contract may limit non-recourse protection to certain scenarios (e.g. buyer insolvency).

Put simply, with recourse, the seller retains more risk but pays less; with non-recourse, the factor takes on more risk (for a higher cost), providing the seller full credit cover.

Benefits of Factoring: Liquidity, Risk Mitigation, and Growth

For credit managers and business leaders, factoring offers several advantages:

Improved Liquidity and Cash Flow: Factoring turns slow-paying invoices into immediate cash. Companies receive payment often within 24 hours of invoice submission, which can dramatically ease cash-flow constraints. This “cash now” model lets firms meet payroll, pay suppliers, or reinvest in operations without waiting for customers.
Credit Risk Transfer: Factoring shifts some or all credit risk of receivables to the factor, especially under non-recourse agreements. By effectively selling the receivable, the seller outsources the risk of buyer default. For example, if a buyer fails due to bankruptcy, a non-recourse factor will bear that loss. Even with recourse factoring, the factor typically performs credit checks and collections, reducing the seller’s workload and exposure. The factor’s expertise in credit underwriting can improve risk management.
Focus on Core Business: Since the factor handles collections and credit evaluation, the seller’s staff can concentrate on core activities (production, sales, service) rather than chasing payments. Factoring often includes “back-office” support, such as credit checking and invoice management. This can be especially valuable for fast-growing companies that need to scale operations quickly; instead of negotiating ever-larger bank lines, they use receivables as collateral-free capital.
Supports Growth and Expansion: With better access to cash and reduced risk, companies can safely extend more credit or take on larger orders. Factoring can enable a business to offer open account terms to customers that it otherwise might insist on cash-on-delivery. In turn, this can expand market opportunities. For instance, a startup with a major new customer might factor those large invoices to fuel rapid growth, as it leverages the buyer’s credit (rather than its own limited track record) to obtain financing.
No New Debt: Factoring is an asset sale not a loan. This means it does not appear on the balance sheet as debt. For credit managers and CFOs, factoring can be an attractive alternative to bank loans or lines of credit, particularly when balance-sheet leverage is a concern. Because it is not lending, factoring won’t increase debt ratios, although it does come with a cost (the factoring fee).
Flexibility: Many factoring programs are flexible. Sellers can often choose which invoices or customers to factor. For example, a business might factor invoices only for slow-paying customers while funding faster-paying invoices internally. There are no mandatory amortization schedules like loans; financing scales with sales (you factor more invoices as sales grow).
Complementary Risk Coverage: Factors typically vet buyers before agreeing to buy receivables. In non-recourse deals especially, the factor may require or offer credit insurance on the buyer’s account to cover default risk. This means factoring can dovetail with credit insurance strategies: factors often have credit insurance in place for many buyers.

In summary, factoring can de-risk trade credit by converting receivables into cash, outsourcing credit control, and (with non-recourse) effectively insuring against bad debts. At the same time, it provides liquidity that fuels growth.

Common Misconceptions and Challenges

Despite its benefits, factoring is sometimes misunderstood. Common myths and challenges include:

“Factoring is only for troubled companies.” In fact, this stigma is outdated. While factors do work with younger or less-creditworthy sellers (since the financing depends on buyer credit, not seller credit), strong companies use factoring too. The key is the buyer’s credit. A robust example: a new company servicing a top-tier client may still qualify for factoring even if it has no credit history, because the factor trusts the large buyer to pay. Thus, factoring is a growth tool as often as a rescue tool.
High Cost Concern: It’s true that factoring fees are often higher than bank loan interest. Factors charge for the convenience and risk assumption (non-recourse factored invoices can be 1–5% of invoice value, depending on terms). However, this cost can be justified if it unlocks new business or avoids expensive missed opportunities. In many cases, the effective cost of factoring compares to credit card processing fees per invoice. Crucially, factoring fees are one-time per transaction, not compounded over months like interest, so comparing it to a long-term loan interest rate can be misleading.
“Factoring is a Loan”: Legally, factoring is an asset sale, not a debt. Many accountants mistakenly treat factoring fees like interest. This misconception can inflate the apparent APR of factoring. In reality, factoring fees are charged per invoice (at time of sale or payment), not as a continuous interest on a loan balance. Companies should remember they aren’t repaying a loan principal; they sold a receivable asset at a discount.
Loss of Customer Control: Some sellers worry that factors will upset customers by contacting them. Reputable factors typically handle communications professionally. Moreover, there are confidential factoring structures where the seller continues its collections under the radar, and the factor only intervenes if a payment issue arises. Even when buyers are notified (disclosed factoring), companies often find that prompt factor follow-up can actually accelerate collections rather than harm relationships. Clear agreements and communication can mitigate these concerns.
Dependency Risks: Reliance on factoring can create dependency. If a seller factors too many invoices or at high costs, it may erode margins or flexibility. Additionally, some factors require exclusivity (all receivables must be factored) or charge minimum fees. Credit managers should carefully review contract terms, including notice periods and termination clauses.
Limited Coverage: Factors may not finance every invoice. High-risk customers or disputed invoices may be excluded or advance rates reduced. In recourse factoring, sellers still carry credit risk on these excluded receivables. In non-recourse factoring, factors often require credit insurance or additional guarantees on risky buyers.

By understanding these issues upfront, credit managers can select the right factoring partner and structure. Proper due diligence and contract review (often with legal counsel) is essential to avoid unwanted surprises.

Conclusion

For B2B credit professionals, factoring is an important tool in the toolbox for de-risking trade credit. By allowing sellers to convert receivables into cash and transfer credit exposure to a specialist, factoring can improve liquidity, support growth, and cushion the impact of slow-paying or risky customers. It is not a one-size-fits-all solution – factors vary in terms, costs, and recourse policies, and careful analysis is needed to weigh fees versus benefits. However, when structured properly, factoring complements other credit-risk strategies (such as credit insurance) and can significantly strengthen a company’s financial resilience. In today’s U.S. market – with growing adoption, new fintech platforms, and clear legal framework – factoring continues to evolve as a viable alternative to traditional credit lines for managing working capital and credit risk.