Cash flow issues affect nearly every small business.
To prevent your business from going into debt, you need to fix these cash flow issues by influxing the business with capital.
This is when a factoring company can help.
However, your success in this outcome of this situation depends on understanding the type of agreement that you may have with the factoring company.
With factoring there are recourse and non-recourse arrangements.
Knowing the difference between these two arrangements can help you shape your overall business and cash flow strategies.
Two types of factoring
While both provide consistent cash flow for your business, it is important to know the difference between the two before deciding on how to fund your company’s working capital needs.
What is recourse factoring?
Recourse factoring is the most common type of invoice factoring.
Recourse factoring is when, after the factoring company made every effort to collect the money on your behalf but couldn't get your customer to pay, you are responsible for the created debt.
In other words, you are required to buy back from the factoring company the unpaid invoice and try to collect by yourself the created debt from your customers.
If you are also unsuccessful in collecting the debt from your customers then you must accept the loss.
The advantages of recourse factoring
Here are a few reasons why you might want to consider recourse factoring:
- Less expensive than non-recourse factoring.
- No collections work unless your broker or shipper doesn’t pay.
- Easy to qualify for since you’re assuming the risk of bad debt.
The disadvantages of recourse factoring
Entering into a recourse factoring agreement does come with more risks of invoice factoring:
- If the broker or shipper does not pay, you have to buy back that debt and collect it yourself.
- This buyback can have a huge impact on your cash flow.
- If you can’t buy back the invoice, you might end up in collections yourself.
What is non-recourse factoring?
On the other hand, non-recourse factoring means that the factoring company assumes most of the risk of the non-paid invoice by your customers.
In this case, the factoring company is responsible for all attempts to collect the payment from your customer. However, if your customers don't pay back, the factoring company accepts that loss.
The catch with non-recourse factoring is that it only covers specific situations which means that you may still be responsible for the debt if your customer doesn't pay.
For example, a factoring company might limit non-recourse to customer businesses that have closed or declared bankruptcy, thus holding you, the borrower, liable for any outstanding debt.
Because non-recourse factoring is riskier for the factoring company, it’s less common than recourse factoring.
If a company does offer non-recourse factoring, you’ll typically need to show that your customers have consistent records of on-time payments and strong credit histories to qualify.
The benefits to borrowers are two-fold. They get the cash they need to alleviate a crunch with zero risks if any of their customers do not pay. Non-Recourse factoring also works like credit insurance in the sense that the borrower gets access to the factoring money with no risk to themselves barring there is no fraud.
The advantages of non-recourse factoring
On-recourse factoring has two significant advantages over recourse factoring:
- Someone else does your collections for you, even on covered bad debt.
- You only have to buy back the invoice if the debt is uncollectible for a reason that isn’t covered.
- Disadvantages of non-recourse factoring
You’ll also want to consider the drawbacks of non-recourse factoring:
- More expensive than recourse factoring - Generally, non-recourse factoring is more expensive than recourse factoring. The higher price serves to protect the factoring company from potential bad debt.
- Limited protection.
- May only be available for specific companies.
Differences between recourse and non-recourse factoring
The main difference between recourse and non-recourse factoring is which party is ultimately held responsible for customer nonpayment.
With recourse factoring, the business is responsible.
But with non-recourse factoring, the factoring company is responsible, although there may be some stipulations based on the terms of the agreement.