Should You Factor Invoices That Are Collections Problems?

Factoring companies often get calls from prospective clients interested in factoring invoices that are hard to collect. These invoices tend to be substantially past due and have become collections problems. The prospect hopes that the factor will buy the invoice and take on the collection problem.

Past-due invoices that have become collections problems cannot be factored. Factoring companies won’t buy those invoices because they are considered to have low credit quality. Furthermore, even if you could finance those invoices, the transaction would eventually unravel. This article explains why troubled invoices cannot be factored. We cover:

  1. How does factoring work?
  2. What types of invoices do factors buy?
  3. What happens if an invoice defaults?
  4. How to use a factoring company effectively

1. What is factoring?

Factoring is a tool that you can use to improve your cash flow. It works by financing invoices from creditworthy clients that pay on net-30- to net-60-day terms. Factoring transactions are structured as asset purchases. The factoring company buys your invoices and provides an immediate payment at a small discount.

Factoring companies can buy invoices with or without recourse. The methods are similar on the surface but handle collections problems differently.

a) Recourse factoring

Factoring companies that use recourse factoring buy your invoices expecting your customer to pay the invoice in 90 days or less. Any invoice that is not paid in 90 days is returned to the factoring client for a refund. The factor can return the invoice regardless of your customer’s reason for not paying.

b) Non-recourse factoring

Non-recourse transactions are similar to recourse transactions, with one important exception. The factoring company will not return an invoice if your customer does not pay it because of bankruptcy. The factoring company can return invoices that are not paid within 90 days for other reasons, such as disputes, etc.

Non-recourse factoring is commonly misunderstood by many clients who think it offers complete protection against non-payment. It does not. It protects only against invoices that default due to a customer bankruptcy during the 90-day factoring window. Factoring companies offer variations of these programs, so you should consult with your factor to get the specific details of their platform.

2. What type of invoices do factoring companies buy?

Factoring companies buy only invoices from companies that have good commercial credit. They usually check your customer’s credit through a bureau such as Dun and Bradstreet or Equifax.

The invoices usually must be on net-60-day terms or less. However, factoring companies can be flexible about this limit based on the transaction details. Lastly, the products or services described in the invoice must have already been delivered to your customer. Factoring companies usually verify an invoice before buying it to ensure its accuracy.

3. What happens if an invoice defaults?

What happens in case of default depends on the reason for the default and the type of factoring you use. If your client does not pay an invoice because of a dispute or they are a bad payer, you must absorb this cost. Factoring does not offer protection against disputes. The factor is not in a position to mediate or resolve the issue. However, factoring companies can help you minimize the chance of working with a bad payer by reviewing your customer’s commercial credit.

The factor absorbs the loss only if you have a non-recourse agreement and your invoice defaults because of a declared bankruptcy during the 90-day window. This is the main benefit of non-recourse plans. Note that factoring companies usually avoid buying invoices due from companies at risk of insolvency.

a) Returning an invoice to the factor

Returning an invoice to a factoring company can be financially challenging. Your company must return the initial advance and pay the factor’s fees. This outcome is why trying to finance questionable invoices is a bad idea. It won’t help you and can be very expensive.

Factoring companies usually try to provide an accommodation to minimize the financial impact of returning an invoice. Rather than asking for the funds up front, they may deduct them from future advances. Each factoring company has its process for handling this scenario.

4. How to use a factoring company effectively

You should use accounts receivable factoring only as a tool to finance slow-paying invoices from creditworthy customers. In these cases, factoring should improve your cash flow and provide a platform for financial growth.

Factoring companies can also help you review the creditworthiness of new customers. Customers who don’t meet the credit requirements of factoring should be asked to pay up front or given minimal credit.

Lastly, invoices from existing customers who aren’t good payers should not be factored. Instead, these invoices should be handled by your collections department or a collections agency.

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