Invoice Factoring is an increasingly popular form of alternative business funding; growing more since it has become tougher for businesses with imperfect credit to use traditional finance products.
Definition of Invoice or Business Factoring
Invoice factoring is sometimes referred to as ‘factoring’, or ‘debt factoring’. It is a financial product that enables businesses to sell unpaid invoices (accounts receivable) to a third-party factoring company (factor). The factoring company buys the invoices at a percentage of their total value and then takes responsibility for collecting the invoice payments.
Why Would a Company use a Factoring Company?
The simple answer to this is to speed up incoming cash flow as receiving payment for invoices can sometimes be a lengthy process. One of the problems for many businesses is that payment terms can be between 30 to 120 days, and this can lead to cash flow issues. The gap in cash flow during this period has often been filled by either bank overdrafts or business loans. However, where businesses may have less than perfect credit these options may not be available. Invoice factoring, therefore, can offer a useful solution for similar situations.
How Does Invoice Factoring Work?
Most factoring companies pay in two instalments, the first covering the bulk of the receivables (fulfilling your need for instant cash-flow) and the remainder when your client settles their invoice, minus any factoring fee. The basic steps are as follows:
(a) You submit details of your invoices to the factor to determine if you are eligible. The factor will assess how risky they feel the loan is (this is industry specific, as well as about your particular clients) and will then give you their quote.
(b) When agreement has been reached, the factor will advance you the money.
(c) The factor will then commence collection of the invoice with your customer
(d) Once the invoice has been collected, the factor will pay you the remainder of your money, minus their fee
Advantages of Invoice Factoring
- A quick, safe source of cash flow
- It can lower time spent on administration since the factor assumes responsibility for collecting the debt
- Factoring amounts can easily expand and contract with your sales ledger.
- Factoring is less expensive than turning to equity investors
- As experienced debt collectors, factoring companies professional and ‘gentle reminders’ can improve your customer’s payment times on a long-term basis.
Disadvantages of Invoice Factoring
- It could affect customer relationships since you must let your customers know a third party is involved with collecting your invoices
- The costs are higher than a bank loan, so this type of finance works best for businesses with a high-profit margin that can absorb the costs.
- May reduce the scope for additional borrowing
- Loss of Control – Handing over responsibility to a third party for accounts receivable means you will have to give up an element of control
Can a Business with bad Credit Apply for Invoice Factoring?
Because factoring companies are more interested in the strength of your customer’s credit rather than your own, it can represent a useful form of business finance for businesses with poor credit.
How Does a Factoring Company buy Invoices?
Most factoring companies purchase invoices in two instalments. The first instalment – the factoring advance – covers about 80% of the receivable (this amount varies). The remaining 20%, less the factoring fee, is rebated as soon as your client pays the invoice in full. Here are the steps:
- You submit the invoices for purchasing
- The factoring company sends you the advance (e.g., 80% of the invoice)
- Your client pays 30 to 120 days later
- The factoring company sends you the rebate (e.g., 20%, less the fee)
How mow Much Does Invoice Factoring Cost?
Invoice factoring costs differ depending on some factors including the value of invoices in question, the size of the company, and the apparent level of risk for the lending partner. The costs are broken down into a service charge, and the discounting fee itself. There may also be additional fees for things like credit protection, or a decision to end the service early. Read our full article here about invoice finance and factoring costs.
What’s the Difference Between Invoice Factoring and Discounting?
The key difference between invoice factoring and discounting is that while discounting allows the business to retain control of it’s sales ledger and invoice collection, factoring gives the invoice finance provider that role. Invoice Factors will manage their own credit control, and chase customers directly for the settlement of invoices.
What is the Meaning of Reverse Factoring?
Reverse factoring, also known as supply chain financing, is a finance solution initiated usually by a larger company who introduces a smaller one to it’s invoice finance provider. The invoices to the smaller company are then secured against the larger invoices of the bigger company. So it’s a case of a big company lending its financial security to someone they work with, securing the stability of its supply chain in the process.
Currently, the process accounts for a small percentage of the overall invoice factoring market.