11 Min. Read

What Is Invoice Factoring? A Small Business Owner Guide

January 23, 2024

Invoicing is a major part of any business. It’s how you get paid for the products you provide. However, not all clients are good about paying their invoices. This can result in outstanding income that you need. Thankfully, there are companies that help collect on these invoices. The process itself is called invoice factoring.

One of the most important financial decisions you can make for your business is choosing a factoring company. Invoice factoring has so many different aspects that you should know about.

Here’s What We’ll Cover:

What Is Invoice Factoring?

How Does Factoring Work?

When Should Your Company Use Factoring?

Advantages and Disadvantages of Invoice Factoring

Factoring, Financing… What’s the Best Solution for Your Business?

Types of Invoice Factoring

How to Choose the Best Factoring Company for Your Business

How Much Does Invoice Factoring Cost?

Is Invoice Factoring Right for My Small Business?

Key Takeaways

What Is Invoice Factoring?

Factoring is a type of invoice financing in which your company sells some or all of its outstanding invoices. The invoices are sold to a third party to improve cash flow and revenue stability. An invoice factoring company pays most of your invoiced amount immediately. It then collects payment directly from your customers.

Invoice factoring is also known as accounts receivable factoring or debt factoring.

How Does Factoring Work?

Factoring invoices refers to the process of selling control of your accounts receivable, in part or in full. This enables you to borrow money based on unpaid invoices from your customers. Factoring companies will buy your receivables for the invoice value minus a factoring fee after they form an agreement with you. It works like this:

First, you sell or provide your products to customers.
Then you invoice them for the goods or services.
You then sell the invoices to a factoring agency. After verification that the invoices are valid, the factoring company immediately pays you up to 80-90% of the invoiced amount.
Customers pay the factoring company directly. If necessary, the factoring company chases invoice payments.
Upon receiving payment in full, the factoring company pays you the remaining invoice amount. The amount may be reduced due to invoice factoring fees.

When Should Your Company Use Factoring?

Factoring may be beneficial to your company if you have many outstanding invoices and your cash flow is suffering. You can release those funds almost immediately, or at least a large part of them with invoice factoring financing. With that money, you could:

Bridge short-term expenses
Repay a loan
Take advantage of seasonal business opportunities
If cash flow is otherwise constrained

Advantages and Disadvantages of Invoice Factoring

Advantages of Invoice Factoring

The decision of factoring in your invoices may benefit your business. Here are some ways:

Better and immediate access to cash. By factoring your invoices, you will be able to receive the majority of your payments almost immediately. This is much better than waiting for the money to come in (possibly after extensive chasing on your part). This makes planning and forecasting more accurate. This way, you can take advantage of opportunities that might otherwise be inaccessible.
The business has a better chance of surviving if it has good cash flow. Business failure is often caused by poor cash flow, and invoice factoring can keep yours healthy – if used wisely. As a startup company, you could benefit from invoice factoring.
For short-term financing needs, factoring is usually cheaper and easier to obtain than a bank loan. It also eliminates debt management hassles. This could save you a lot of money, depending on the size of your customer base.
You could reduce your business overheads using invoice factoring services. Even though invoice factoring may have fees, they are likely to be less expensive than hiring a dedicated credit control team. It may also improve people’s morale in your accounts department, as chasing down payments is often a stressful job.

Disadvantages of Invoice Factoring

As with anything, there are both pros and cons, so here are the cons of invoice factoring:

Factoring is not suitable for companies with few customers. Invoice factoring is not suitable for companies with fewer than ten main customers. Invoice factoring companies try to spread risk as widely as possible. They try to avoid sending a lot of invoices to just a few customers.
Factoring typically requires a big commitment. Sometimes it’s possible to factor a small number of invoices. However, most factoring companies will want to factor your entire accounts receivable. It’s also possible that they will try to lock you into a long-term contract for at least two years. As a result, invoice factoring cannot just be dipped into whenever you like. This is an important business decision.
If you have risky customers, factoring companies will charge more. Factoring companies work to accurately determine the risk of late payments or non-payment of debts. This means their customers are carefully assessed. Your fees will reflect your or your customers’ high-risk status.
In the event of a failure, there may be additional expenses to cover if your clients prove to be less generous payers than expected. Unless you pay an extra fee for non-recourse factoring, you may have to repay the amount the factoring firm has already paid you. Factoring companies don’t take over bad debts for free. Like you, they want to earn money.
Factoring your invoices may harm your relationships with your customers. You risk losing customers if the factoring company pursues the debt aggressively or coldly. In addition, they may think your business is doing poorly if a factoring company is involved.

Factoring, Financing… What’s the Best Solution for Your Business?

There’s a difference between Invoice factoring and invoice financing. They differ primarily in who is responsible for collecting payment from clients.

The invoice financing method uses your outstanding invoices as collateral for a loan. This loan is placed against your accounts receivable. If you obtain payment from your client, you repay the invoice financing company the loan plus interest and fees. Your business continues to manage the relationship with your clients. You also manage the collection process.

You essentially sell your outstanding invoices to a lender who buys them from you. They collect them from your clients with invoice factoring. After collecting from your client, the factor advances you a portion of the balance (minus fees).

When comparing invoice factoring and invoice financing, you need to take into account the payment structure:

If you use invoice financing, you can advance up to 100 per cent of the outstanding invoices. However, you must repay the lender every week over a set period of time – typically 12 to 24 weeks.

Invoice factoring gives you 70 per cent to 90 per cent of the invoice. The remainder is repaid based on how long it takes for your customers to pay their invoices.

Types of Invoice Factoring

There are different types of invoice factoring. Check out the following ways that invoices can be factored.

CHOCC Factoring

CHOCC factoring is a type of invoice factoring where you pursue payment instead of the factoring company. CHOCC stands for ‘Client Handles Own Credit Control.’

Confidential Factoring

Confidential factoring involves confidentiality. In short, it means your customers aren’t aware that they’re dealing with a factoring company.

Credit Control

Credit control is an act of ensuring a customer pays the money they owe. It is often used interchangeably with debtor management, and debtor tracking. One way to make sure customers pay is to send emails or phone calls, both before and after the payment is due.

Debt Factoring

Debt factoring is the process of selling some or all of an organization’s outstanding invoices to a third party. This is done to improve cash flow and revenue stability.

Disclosed Factoring

The most common type of invoice factoring is disclosed factoring. This is when your customers are aware that they are dealing with a factoring company.

Non-recourse Factoring

Factoring with higher fees that doesn’t charge you back for bad debts is called non-recourse factoring.

Recourse Factoring

An invoice factoring company may charge you back for bad debts as part of its recourse factoring.

Selective Factoring

Selective factoring is a type of invoice factoring where an individual or small bundles of invoices are factored. This is done instead of large amounts or the entire sales ledger.

How to Choose the Best Factoring Company for Your Business

Factoring companies play a large role in business. As such, it’s important to choose the best invoice factoring provider to suit your needs.

1. Select and Interview the Candidates

Identify three or four factoring companies. Ask them questions based on the information provided in the previous section. It is advisable not to interview more than three to four companies at one time – this can lead to overwhelming feelings.

Continue interviewing companies in four groups until you have selected two that are good fits for you.

2. Start the Application Process

The application process for most factoring companies is similar. Depending on the size of your business, you may need to provide some information about yourself and your company. You will also need to provide an Invoice Aging Report.

You might also need to submit a Profit & Loss Statement and a Balance Sheet in some cases. Factoring companies should be able to provide a proposal within one business day unless your situation is complex.

3. Compare Their Terms to Determine the Best Deal

Factoring proposals can be similar, but they often differ significantly. There will be various rate structures, advances, terms, recourse, and non-recourse options. Different proposals differ in ways that make comparing them difficult. It is important to be keen on the numbers.

4. Make the Decision

The factoring company issues its legal documents after you make the decision. They must be signed and, in some cases, notarized. In most cases, this process takes a few days, though it may take longer in special circumstances (if your transaction is complex).

How Much Does Invoice Factoring Cost?

There are a few things that determine invoice factoring rates. They are:

Invoice dollar amounts
Invoice volume
Industry
Client creditworthiness

As a competitive industry, most companies offer monthly rates between 1.15% and 3.5%. These rates are usually prorated for shorter-term agreements. You could, for example, quote a monthly rate of 1.5% and prorate it as 0.5% per ten days.

Small companies factoring amounts under $10,000 may receive rates above 3.5%. Additionally, medical factoring and construction factoring have higher rates. This is due to risk and workload.

Is Invoice Factoring Right for My Small Business?

If you have an invoice-based client payment system, invoice factoring may be right for you. Here are a few reasons why it may be the right move for you:

Payment terms are offered to your customers, your bill is on the invoice, and you receive a substantial number of invoices each month.
You don’t have credit. The fact that approval largely depends on your invoice quality rather than your credit score
Your business has seasonal shifts that cause short-term cash flow problems.
No collateral can be used for another type of financing (e.g., equipment, automobiles, property).
Your business is rapidly growing and you need additional working capital for inventory or supplies.

Despite the above, there are still other factors to consider, even if one or more of them applies to your business.

The result of factoring rates and fees will be less money coming into your business than you planned. When time is of the essence, that doesn’t matter as much. In most cases, it’s better to wait for invoices to be paid if you haven’t added additional margin to account for factoring costs.

If your margins are already tight, invoice factoring can eat into your profits. That can obviously harm your bottom line.

You must evaluate how a factoring agreement will impact your bottom line before you sign it. It means you’ll have to decide whether to wait it out or to seek assistance through alternative financing options.

Key Takeaways

When it comes to invoicing, you always want to collect. However, not all customers are going to pay on time, and some might not pay at all. That’s where invoice factoring comes in. If you need help collecting on outstanding invoices, you can hire a factoring company. They’ll collect payment for you, for a price. If you want more articles like this, check out our resource hub! We’ve got plenty more just like it!