Factoring vs Line of Credit: Commercial AR Working Capital Decision
Why this matters
Commercial work pays on 60 to 120 day cycles while payroll, materials, and fuel demand weekly cash. Residential trades crossing into commercial usually hit a working capital wall around 25 to 35 percent commercial revenue mix. The two tools that bridge that gap are accounts receivable factoring and a bank line of credit secured by AR. They look similar from the operator chair but have very different cost structures, covenant burdens, and customer notification footprints. Picking the wrong one bleeds margin or trips a default at the worst possible moment.
How factoring actually works
Factoring is the sale of a specific invoice to a third party (the factor) at a discount. Two flavors exist:
- Recourse factoring: if the customer does not pay within the agreed window (commonly 90 days), the factor charges the invoice back to your operating account. You retain ultimate credit risk. Discount rates are lower because the factor is essentially lending against your collection ability.
- Non-recourse factoring: the factor assumes credit risk on the named obligor for credit-driven non-payment (bankruptcy, insolvency). It does not cover disputes, billing errors, or backcharges. Discount rates run materially higher and the factor underwrites each customer separately.
Funding flow: you sell the invoice, the factor advances a percentage of face value (commonly 75 to 90 percent depending on industry and obligor), holds a reserve for chargebacks and disputes, and remits the reserve net of fees once the customer pays the factor directly. The customer sees a Notice of Assignment under UCC Article 9 and pays the factor, not you.
How an AR line of credit works
A bank line of credit secured by AR is a revolving facility. The bank files a UCC-1 financing statement under UCC Article 9 against your receivables, advances against a borrowing base (typically eligible AR under 90 days, excluding concentrations and intercompany), and you draw and repay as cash cycles. Customers continue paying you directly; there is no notice of assignment unless you default.
Pricing is interest plus an unused-line fee. Covenants typically include:
- Fixed charge coverage ratio
- Tangible net worth floor
- AR concentration limits per customer
- Borrowing base certificate due monthly
- Annual audited or reviewed financials
- Field exam at facility inception and annually
Decision matrix
| Factor | Factoring | Bank Line of Credit |
|---|---|---|
| Approval speed | Days | Weeks to months |
| Underwriting focus | Customer (obligor) credit | Your balance sheet + covenants |
| Customer notification | Yes (Notice of Assignment) | No, unless default |
| Cost structure | Discount fee per invoice | Interest + unused-line fee |
| Covenants | Light | Full bank package |
| Concentration tolerance | High (will buy one big invoice) | Capped, typically 20-25 percent per obligor |
| Recourse on disputes | Always you | Always you |
| Scaling friction | Easy to add new obligors | Borrowing base re-audit needed |
| Best fit | Lumpy commercial mix, fast growth, weak balance sheet | Steady AR, clean financials, multi-year banking relationship |
When factoring is the right tool
- You are pre-bankable: under 2 years operating history, no audited financials, or recent losses on the P&L.
- A single new commercial customer doubles your AR base and breaks your existing LOC concentration limit.
- Cash conversion cycle exceeds 75 days and payroll cannot wait.
- The obligor is investment grade (REIT, national GC, federal agency) and the customer credit underwrites better than yours does.
- You need spot funding for one job, not a permanent facility.
When a line of credit is the right tool
- You have at least 24 months of clean financials and a banking relationship.
- AR is diversified (no customer over 20 percent of revenue).
- Average invoice cycle is under 60 days and you need smoothing, not survival.
- Customer-facing image matters for your brand (Notice of Assignment can rattle residential or boutique commercial obligors).
- You want the cheaper cost of capital and accept the covenant discipline.
Hybrid pattern
Mature commercial-mix trade businesses often run both:
- LOC handles the diversified base book
- Spot factoring handles new commercial obligors during the first 6 to 12 months until the obligor proves payment behavior and can fold into the borrowing base
Run a monthly borrowing base reconciliation that excludes any factored invoices from eligible AR. Double-pledging the same receivable is fraud under most loan agreements and a defaulting event.
Notices of Assignment under UCC 9-406 are legally binding on the account debtor. Once the obligor receives the notice, paying you (instead of the factor) does not discharge the debt and the factor can still demand payment from the obligor. Train AP at every commercial customer before you start factoring or you will create payment chaos.
Tax and accounting notes
- Factoring discount is an operating expense on the P&L (interest-equivalent on a non-recourse facility may have specific treatment; consult your CPA).
- LOC interest is deductible business interest subject to the Section 163(j) limitation for businesses over the gross receipts threshold.
- Both facilities require disclosure in financial statement footnotes under GAAP.
- Recourse factoring transactions generally remain on the balance sheet as a secured borrowing. Non-recourse may qualify as a true sale and remove the AR from the balance sheet entirely.
References
- UCC Article 9 (Secured Transactions) and 9-406 (Notification to Account Debtor), Uniform Law Commission
- IRC Section 163(j) Business Interest Expense Limitation, 26 USC 163
- FASB ASC 860 Transfers and Servicing
- Federal Reserve Regulation U (margin credit), 12 CFR Part 221
- Equipment Leasing and Finance Association (ELFA) Survey of Equipment Finance Activity