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Invoice factoring: What is it and how does it work?
Invoice factoring frees up cash flow for small businesses.
Cash flow is crucial for any business, but it’s essential for micro-businesses and small-to-medium-sized businesses (SMBs). Business moves fast, and having a good handle on your cash flow will set you up for success.
You can use several methods for managing cash in your business, but invoice factoring is an effective option if you want to avoid debt. You sell accounts receivables to a third-party factoring company at a discount, which allows you to pay for supplies and cover payroll without waiting for customers to pay their invoices.
Of course, this method isn’t without its risks. Relying too heavily on invoice factoring could complicate your cash flow going forward and risk the goodwill you’ve built with your customers.
Ultimately, you must decide whether this option is a wise decision for your business. In this guide, we’ll explain what invoice factoring is, how it works, and its pros and cons. Learn if invoice factoring is right for you.
What is invoice factoring?
Invoice factoring is a short-term loan for small businesses needing an immediate cash infusion. It’s a type of debtor finance where a business sells its invoices to a third-party factoring company. The factoring company immediately pays the business some of the invoiced amount and collects payment directly from customers.
Unlike invoice discounting, you don’t get the full amount of the invoice all at once. However, you also don’t owe interest, which could make factoring more affordable than discounting, depending on your factoring terms.
Invoice factoring could be a good option if you want to improve cash flow. It provides immediate funds that you can use to cover any expenses in your business, from daily bills to investment opportunities. As a small business, cash flow gives you the flexibility to say yes to more — even when you’re experiencing cash flow shortages caused by delayed customer payments.
Small businesses often don’t have the same resources as large businesses, so every unpaid invoice risks your business’s financial health. Fortunately, invoice factoring for small businesses can also stabilize your business. This process converts accounts receivables into cash while you wait for customers to pay their invoices.
In the short term, invoice factoring helps improve a company’s cash flow and revenue stability. It offers a range of other benefits, including:
- Streamlined cash flow. Receiving an advance on your invoices provides a steady cash flow, especially if you have longer payment terms with your customers. Invoice factoring ensures your business has the funds to keep the lights on, which can be incredibly helpful for small businesses.
- Time saved. You don’t have to worry about collecting customer payments with invoice factoring. The factoring company handles that end of the transaction, freeing you up to focus on the core of your business instead of chasing down late payments.
- Growth support. Some business owners use invoice advances to pay for day-to-day expenses, but you can also use these funds to reinvest in your business. Buy inventory, hire employees, or invest in time-sensitive opportunities by filling your bank account at the right time.
How does invoice factoring work?
The process is straightforward: Convert invoices into cash on hand.
1. Find a provider.
Invoice factoring involves your company sending a copy of an invoice to a factoring company. The factoring company then lends you a percentage of that invoice. This “advance” on your invoice allows you to reinvest funds into your business and fuel more growth.
To execute this relationship, your company must enter into an agreement with a factoring company that explicitly outlines these terms, including the advanced rate (the percentage of the claim amount you receive), factoring fees, and payment deadlines. Be sure to do your research before entering into a factoring agreement.
Factoring agreements usually require specific payment deadlines for your customers. Ensure these payments work with your existing cash flow cycle so you don’t hit any snags.
2. Submit the invoice.
Once you have an agreement with the factoring company, you can start submitting invoices to them. Your company sends the factoring company a copy of each customer invoice you want an advance for, which initiates the factoring process.
3. Receive cash.
The factoring company will assess the value of your invoices and give you an advance ranging 70%–90% of the invoice’s value. You don’t have to wait for the customer to pay — you receive cash immediately to cover operating costs or any other expense that can’t wait.
Every factoring company has its own advance rates, which is the percentage of the invoice amount they’ll advance to you. This rate determines how much you’ll receive in immediate funds, so make sure it’s enough to cover your planned expenses. If it isn’t, you’ll have to wait for the customer to pay in full anyway, and it might not make sense to factor in the invoice.
4. Collect customer payments.
The factoring company takes over collecting payments from your customers. You’re off the hook for asking customers to pay their invoices, although this strategy could damage the customer relationship if they aren’t expecting to interact with a third party. Always warn customers that a third-party company will process their payments so they aren’t surprised.
5. Receive final payment and fees.
The factoring company collects the full amount of the invoice from the customer. They subtract fees for their services before forwarding you the remainder of the payment.
Every factoring company has different policies, but they generally charge 1%–5% of the invoice’s total value for their services. For example, the factoring fees on a $5,000 invoice would cost between $50 and $250.
Pros and cons of invoice factoring.
Small business invoice factoring is a strategic tool for specific situations, but it isn’t something to take lightly. Weigh the pros and cons of small business invoice factoring to decide whether it’s the right option for your business.
Pros
Access to quick cash
If your business expands quickly, you might face a problem where you can’t get money in fast enough to pay for the material you need for your products. This is a good problem to have, but it can make for a sticky short-term financial situation. Consider factoring if your business is new and growing rapidly. It might help give you needed short-term assets so you can pay for your future supplies while you get on more secure financial ground.
Zero debt
Debt is a tool. Used wisely, it can set your business up for success. But it can quickly grow out of control, putting an even bigger strain on your business. Traditional financing can take weeks to process and will saddle you with debt, but invoice factoring gives you immediate access to funds — debt-free. If you have urgent expenses, factoring could be much more practical than going to the bank for a loan. Plus, some bank loans will charge you more interest and fees than factoring companies. Factoring is a solid strategy for maintaining a healthy balance sheet and improving your business’s creditworthiness.
Time-saving collections
One of the biggest benefits of invoice factoring is that the factoring company takes over collections for you. Instead of hounding customers to pay their invoices (and potentially damaging the relationship in the process), you allow the factoring company to handle everything for you. You’re still responsible for sending the initial invoice, which is simple with digital tools like Adobe Acrobat for business. The factoring company will manage payment reminders and late payments, taking a big task off your plate. Free up more time to focus on running your business, not chasing down unpaid invoices.
Flexibility
You don’t have to factor in all invoices if you partner with a factoring company. They will only factor in the invoices you send them, so you can send as many or as few as you want. Factoring is a great option to have in your back pocket if you occasionally run into cash flow issues but don’t want to factor in invoices all the time.
Cons
Additional costs
The biggest downside to invoice factoring is the cost. You’re losing out on 1%–5% of the invoice value, which adds up over time. Frequent invoice factoring could harm your overall profitability, so consider whether you are wise to cut into profits for the sake of cash flow.
Liability
Depending on the terms of your agreement with the factoring company, you might be on the hook if your customers refuse to pay. Recourse factoring transfers liability to your business if a customer doesn’t pay an invoice, which means you have to pay back the cash advance to the factoring company. Repayment is a tremendous risk for small businesses, which is why many prefer nonrecourse factoring, where the factoring company assumes liability. Just keep in mind that fees are higher for nonrecourse agreements because you’re asking the factoring company to shoulder the increased risk.
Impact on customer relationships
The factoring company collects payments directly from your customers. This service certainly saves you a lot of time and hassle, but customers might see things differently. Some factoring companies use aggressive collection tactics for customers who fail to pay on time, which could hurt your relationship with that customer. Ensure you work with a professional factoring company that will treat your customers well. Otherwise, you could jeopardize your customer roster, which would have a worse impact on cash flow than if you hadn’t factored invoices at all.
Security
Partnering with a third-party company comes with additional security risks. If you’re worried about data breaches, partner with a reputable factoring company. Experienced providers will clearly explain their security procedures.
Availability
Not all businesses qualify for invoice factoring. The invoice factoring company ultimately gets to choose who qualifies for its services. In fact, the factoring company cares more about your customers’ reliability and creditworthiness than yours. If your customers frequently pay late or encounter payment issues, the factoring provider likely won’t agree to take you on as a customer.
Invoice factoring example.
Invoice factoring isn’t right for everyone, but when used strategically, it can support your business during challenging financial times.
For example, Acme Manufacturing is a small business that builds custom furniture. The company recently went viral on social media and is experiencing a surge in demand, which is good news for the small business, but its customers have 60-day payment terms. This gap in demand and payment creates a cash flow problem for the growing company. Acme Manufacturing decided to use invoice factoring to keep up with orders while waiting for customers to pay.
Acme forwards a $50,000 invoice to the factoring company. After reviewing the invoice and the customer’s creditworthiness, the factoring company agrees to advance $42,500, or 85% of the invoice value. This cash infusion allows Acme Manufacturing to buy raw materials and continue producing furniture without interruption.
Acme focuses on building furniture while the factoring company works on collecting the $50,000 payment from Acme’s client. Once the client pays the invoice in full, the factoring company subtracts a 3% factoring fee of $1,500 and forwards the remaining balance of $6,000 to Acme. So, in total, Acme Manufacturing receives $48,500 ($42,500 advance + $6,000 remaining balance) from the original $50,000 invoice.
Frequently asked questions.
What are the disadvantages of invoice factoring?
The biggest disadvantage of invoice factoring is additional costs. Factoring fees range from 1%–5% of the invoice’s total value, potentially hurting a business’s long-term profitability. Offloading payment responsibilities to the factoring company could also harm customer relationships. Using these services also comes with additional security risks and availability concerns.
Is invoice factoring legal?
Yes. Invoice factoring is a widely used and accepted way to improve business cash flow. However, work with a reputable factoring company and always review contract terms and fees to protect your business and comply with the law.
What is the average cost of invoice factoring?
Most factoring companies charge 1%–5% of the invoice’s total value. Since this is a percentage-based fee, the total cost depends on the original invoice amount.
What are the two types of invoice factoring?
The first type is recourse factoring, which is when your business is still liable for repayment if the customer refuses to pay an invoice. If the customer defaults on an invoice, your business must repay the factoring company.
The second type is nonrecourse factoring, where the factoring company assumes the risk of nonpayment. If the customer doesn’t pay, the factoring company takes the loss. This option usually comes with higher fees because the factoring company assumes more risk.
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