Dealing with seasonal downturns is fairly common when running a construction business. Business may go slow during certain periods, but you still need to have a steady cash flow to keep your business running.
One of the most common financing methods when you need immediate cash on hand is invoice factoring. Invoice factoring is basically selling your invoices to a factoring company at a discount — you get part of the payment right away and the factoring company handles all the payment collection for the invoices that you sold.
There are two ways of factoring your invoices: recourse factoring and non-recourse factoring. This guide will walk you through the difference between these two types and their respective advantages and disadvantages.
- What is recourse factoring?
- What is non-recourse factoring?
- Differences between recourse factoring and non-recourse factoring
- Choosing between full-recourse factoring and non-recourse factoring
What is recourse factoring?
Recourse factoring — also known as full recourse factoring — is the regular type of invoice factoring in which you sell your invoices to a factoring company but you still remain liable if your clients do not pay the invoices.
When you sell your invoices through invoice factoring, you receive your payment in advance even if your clients are yet to pay the actual invoices. The factoring company takes charge of the collection process. However, payment disputes and other unfortunate circumstances can happen that may cause your client to fail to settle their invoices.
If, say, for example, the invoices that you sold is worth $20,000 but only $15,000 got paid by your clients within the agreed time period — you will have to pay the factoring company the remaining $5,000 out of your own pocket.
Under recourse factoring, you will have to buy the unpaid invoices back from the factoring company if such circumstances occur.
What is non-recourse factoring?
Non-recourse factoring works the same way as recourse factoring. You sell your yet-to-be-paid invoices and you receive payment in advance, while the factoring company takes care of collecting the payment from your clients.
In non-recourse factoring, however, you do not become liable if a client fails to pay their invoices under certain conditions. This appears to be a more convenient option than recourse factoring. However, you must understand that there are conditions that must be met for you to be completely free of any obligation in the event that your client fails to pay up.
Most non-recourse factoring only takes effect if a client fails to release payment because they have declared bankruptcy within the agreed payment period. This means that if a client has not gone bankrupt and simply refuses to pay the invoices, you may still have to buy the invoices back and pay the factoring company.
Differences between recourse factoring and non-recourse factoring
1. In recourse factoring, you are expected to pay back unpaid invoices.
The most obvious difference between recourse factoring and non-recourse factoring lies in which party assumes the debt if a client fails to settle an invoice.
In recourse factoring, you will become liable for the debt and you will have to pay the remaining balance to the factoring company. In non-recourse factoring, as long as certain stipulations are met, the factoring company will assume the debt and you are free to run your business as usual.
2. Non-recourse factoring is more expensive.
Non-recourse factoring has more risks, at least from the lender’s standpoint. A factoring company’s willingness to assume unpaid invoices has a price, which usually means that you have to pay a higher amount if you want to take the non-recourse option.
Paying a higher price for non-recourse factoring means that the cut the factoring company takes is higher. The difference in rates is usually at least 1% — a full-recourse option may cost 3% of the total invoice amount, while a non-recourse option may cost 4%.
Some parties may think 1% is a small price to pay for the peace of mind of not having to worry about a client’s delinquency, while some parties would rather go with the full-recourse factoring option if their clients have good reputations.
3. Recourse factoring is more common.
Between full-recourse factoring and non-recourse factoring, the former is offered by more factoring companies. Some factoring companies do not even offer the non-recourse option as it is way too risky, considering how common payment disputes and issues are in the construction industry.
Both recourse and non-recourse factoring offer fast approval and quick payment processes, so either option is very convenient for parties who are looking to secure immediate cash for their business needs.
Choosing between full-recourse factoring and non-recourse factoring
Invoice factoring is a very effective and relatively low-risk financing method, whether you’re going for the recourse or non-recourse option. However, if you’re deciding between the two options, you must consider their respective advantages and disadvantages to know which choice will fulfill your needs better.
Advantages of recourse factoring
1. It is easier and quicker to secure.
Both recourse factoring and non-recourse factoring methods do not take a long time to secure. However, applying for recourse factoring may take a little quicker simply because factoring companies do not have to be as thorough in screening the credibility and reputation of your clients.
Keep in mind, however, that a good factoring company still looks at your clients’ credit scores to determine the rates and payment terms for your invoices.
2. It is more affordable.
The price difference between recourse factoring and non-recourse factoring may not be as high, depending on the factoring company, but still, recourse factoring is cheaper. This is because the factoring company is taking less risk — if the clients do not end up paying the invoices, you will still be required to cover the remaining balance.
3. It is more flexible with the number of invoices that you can factor.
Most non-recourse factoring options will require you to sell all your invoices and not just piece-by-piece. For recourse factoring, you have more flexibility in deciding how many invoices to sell.
If you’re only looking at invoice factoring as a temporary solution to a temporary cash-flow gap, recourse factoring may be the better option.
Disadvantages of recourse factoring
1. It holds you liable for all unpaid invoices.
The biggest drawback with recourse factoring is having to buy back the unpaid invoices in the event that your clients fail to pay them under whatever circumstances. Whether a client goes bankrupt, disputes your invoice amount, or simply does not want to fulfill their obligation, you will have to cover their balance and pay the factoring company.
2. It may cause you to lose some of your assets.
Sometimes a client may go bankrupt and fail to pay a huge account. If you are a small company that runs on limited finances, having to cover the huge invoice out of your own pocket may cost your business a lot of money.
Consider the amount of the invoices that you are selling and your current financial status before you make a decision on whether recourse factoring or non-recourse factoring is the better option for you.
Advantages of non-recourse factoring
1. It transfers liability for unpaid invoices to the factoring company.
When you choose to go for non-recourse factoring, you are essentially insuring yourself in case your clients go bankrupt and fail to pay their dues. When this happens, the factoring company absorbs the debt and you are free of any obligation to settle it.
Be aware, however, that non-recourse factoring comes with many conditions before it may be enforced. You must always clarify with your factoring company what these conditions are before you sign and sell them your invoices.
2. It can improve your credit rating.
Invoice factoring allows you to have a steady source of capital, and non-recourse factoring may free you of any other liability in case your client loses the financial ability to settle their debt. This is an ideal scenario if you want to build a good credit rating.
3. It protects you when your clients go bankrupt.
The levels of protection that factoring companies offer under non-recourse factoring vary per company. In general, however, non-recourse factoring protects you from the extreme scenario where a client goes bankrupt before they can pay your invoices.
Non-recourse factoring is, therefore, a great credit insurance tool if you have clients that run the risk of going bankrupt.
Disadvantages of non-recourse factoring
1. Not all factoring companies offer it.
Non-recourse factoring is very risky for lenders. They buy yet-to-be-paid invoices from construction parties, but the clients of these parties may end up not paying the invoices altogether. Because of this risk, most factoring companies only go the recourse route.
If you’re considering going for the non-recourse factoring option, you must first look for a factoring company that offers both types.
2. It may not be ideal if your clients have bad credit ratings.
Factoring companies will take a little more time in approving your application as they want to make sure that your clients are in good financial shape. Most factoring companies may not approve you for the non-recourse factoring option if your clients have bad credit ratings.
Some factoring companies may still take you in for the non-recourse option but for a slightly higher rate. You must weigh all your options before you make a decision on which option to choose.