What is invoice factoring?
Invoice factoring is a method of getting cash into your business, fast. It is the act of selling receivables to a factor, or selling invoices, so that you receive cash advances immediately, rather than waiting until the end of an invoice payment period. As part of accounts receivable factoring, you hand over administration for your invoices to the debt factoring company.
With invoice factoring you actively sell your accounts receivable – your invoices – to a finance company, sometimes known only as a ‘factor’. They will then advance you around 80% of the money you are owed, before collecting the invoice themselves. Once the invoice is paid, you then receive the reserve less the fees. With invoice factoring you tend to self-select which invoices to hand over to the factor. They then take over the administration, and are effectively the credit manager, for those invoices.
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Factoring tends to be quite flexible as you are in control of which invoices you factor, and qualifying criteria are generally easy for small businesses to meet. Fees are charged on an invoice-by-invoice basis.
There are a few different methods of invoice factoring, and different companies have slightly different ways of factoring accounts receivable, including both recourse and non-recourse factoring. However, fundamentally they will consider the size of an invoice, and the likelihood of the customer paying, and then advance you the majority of the invoice total. You will receive the outstanding invoice amount, less fees, once the invoice has been paid.
Components of factoring
In factoring, there are a number of different components. The basic components that come into play when you choose to factor accounts receivable are: the advance, the reserve, and the fee.
The advance is the initial ‘bulk’ payment you will receive for your invoice. It is usually paid relatively quickly – within 24-48 hours of the factor receiving the invoice . You might typically expect to receive 80% of the value of your invoice as an advance.
The reserve is the amount of outstanding invoice that the factoring company hold back until your customer actually pays their invoice. This will be the remaining percentage (minus fees) owed to you following the advance. This is typically around 20%.
The fees are the payment to the invoice factoring company for advancing you the money. These are usually worked out as a percentage of the total invoice amount. There may also be other additional fees.
How do factoring companies work? A step-by-step guide
- Invoice your client in your usual way
- Sell and assign the invoice to the factoring company – ensure you are happy with the terms of the agreement (including the fees)
- You will then be advanced the bulk of the invoice amount, usually around 80%.
- From here you can use the advance as needed, whilst you and the factoring company wait for the actual invoice to be paid.
- Once the invoice is paid, the outstanding balance (or reserve) is forwarded to you less the fees.
These steps may vary slightly but this is the general framework of how factoring companies work.
Types of invoice factoring services
Understanding what factoring is in business, and how the different types work, puts you in a stronger position to get the most suitable arrangement in place for improving your cash flow. To do this, run through the different types of invoice factoring services.
Recourse and non-recourse financing
Recourse factoring means the finance company have the right to seek payment from you if your customer fails to pay their invoice. You are still liable for the debt. This could mean you need to repay the advance.
Non-recourse factoring is when the responsibility for the debt is passed to the financial company. If your customer fails to pay their invoice you will not be liable for repaying the advance. However, these two terms aren’t black and white, non-recourse factoring usually operates at different degrees of liability.
Spot factoring is simply single invoice factoring. Instead of factoring multiple invoices or having an ongoing factoring arrangement, spot factoring is a one off process.
In contrast to spot factoring, some small businesses will opt for contract factoring whereby they have an ongoing arrangement, or contract, with the factoring company. Multiple invoices are factored over time.
How to choose the right invoice factoring company
When considering which invoice factoring company to choose you need to have a clear understanding of what you seek to gain and understand which different elements will affect you.
Invoice factoring company fees
Invoice factoring fees can be complicated. You need to fully understand each company’s fee structure before heading into an agreement.
Do you mind your customer knowing you are using a factoring company? Customers may have preconceived ideas about this, and it may lead to souring relationships. There are ways around this, but you need to see where particular invoice factoring companies stand on keeping things confidential.
This is how long it takes for you to be approved for invoice factoring. Some companies have a blanket rule, such as one year of trading. Others will look at your business, your industry, and the types of invoices you want to factor. This process should be relatively quick, taking just a few days in many cases.
How quickly you need the advance
Some companies can advance you the money within just a few hours. Others may take up to a week. The usual window is 24-48 hours.
Experience and reputation
Look at your shortlisted companies in the context of whether they operate within your business niche. Some factoring companies specialise in factoring for particular industries. Check out their ratings and reviews.
Terms and conditions
Not all factoring or financing agreements are created equally. Look at all of the terms and conditions, and if necessary, negotiate.
Invoice factoring costs
The bottom line is that you won’t receive the full amount of your invoice. The finance company needs to cover their risk and make their profit. However, you can negotiate fees.
Costs generally comprise of the fees worked as a percentage of the invoice total, plus any additional charges. These vary enormously.
Invoice Factoring FAQ’s
Can invoice factoring improve my cash flow?
Yes. The primary purpose of invoice factoring is to provide you with cash, quickly, when you need it.
Are there alternatives to invoice factoring?
Yes. You could use your bank overdraft or take out a business loan, or use invoice financing. However, you may not be eligible or able to raise cash quickly enough this way.
What can I use the advance for?
You choose what business activity you use the advance for. It may be to buy resources to meet a new order, or to make some business repairs, for example.
What if my customer doesn’t pay their invoice on time?
This is a factor you should consider when deciding which type of invoice funding or invoice factoring type to go for. Some arrangements are non-recourse meaning you won’t be liable for paying back the advance.
Can I use invoice factoring for just one invoice?
Yes. This is called spot factoring. Alternatively you can have an ongoing arrangement with a factoring company on a contract basis.
How quickly do you get the money?
Once your business, and the invoice, has been approved, you can receive the advance in around 24-48 hours.
Does it matter which invoices I choose?
Yes. It wouldn’t be worthwhile to choose an invoice from a customer who always pays ahead of time and is reliable. Similarly, it may prove an expensive risk to factor an invoice with an unreliable customer with a poor credit check. You may find additional costs coming back on you down the road.
Will my customers know I am factoring their invoice?
Not necessarily. There are options whereby the factoring company can operate in your business name and use your usual invoice collection procedures.
How much does debt factoring cost?
Debt factoring fees are charged on an invoice-by-invoice basis. To see more information about the costs of invoice and debt factoring, see here (link: previous article).
What is the difference between invoice factoring and invoice discounting?
Invoice factoring can be described using a number of different terms including debt factoring, and sometimes, slightly incorrectly, by the term invoice discounting. The terms are often used interchangeably although there are some subtle differences.
In factoring you are selling an asset (invoice) whereas with discounting you are getting a loan for your outstanding invoices. However, all are financial services are provided to bring you cash from, or against, unpaid invoices. They all involve a financial company advancing you the money you have on outstanding debts. The primary difference is to do with who has control of collecting your accounts receivable, or your invoices.
In invoice or debt factoring, the financial company takes control of the invoices including chasing them for payment, and settling late debt. You choose which invoices to factor. Conversely, in invoice discounting, it is your business who remains in control of this process unless you fail to repay the ‘loan’ in which case your invoices are treated as collateral. You still have to seek payment for invoices outstanding in the usual way. Ultimately, it comes down to confidentiality: whether you want a customer to know you are using invoice factoring or not.
What is invoice factoring?
Invoice factoring is the general term given for selling your invoices to a financial company so that you get an advance of cash. The factoring company takes control of chasing unpaid invoices.
What is debt factoring?
The debt factoring definition is the same as invoice factoring.
What is invoice discounting?
Invoice discounting is the practice of using your unpaid invoices as collateral for a loan. Your business is responsible for chasing unpaid invoices.
What is invoice financing?
Invoice financing is the term given to the process through which you can raise cash on unpaid invoices by selling your accounts receivable as collateral to an invoice factoring company or by taking a loan on your accounts receivable through invoice discounting. Another term for this is invoice discounting.