What it is, how much it costs, and why it’s the fastest, most convenient way of boosting your business’ cash flow
What is Invoice Factoring?
Invoice factoring (also known as debt factoring) is a process in which a company’s unpaid invoices are sold to a third party (the ‘factor’) to free up capital.
The invoice factoring service (either a bank or an independent finance provider) buys the owed invoice for a large portion of its value. The factor also assumes responsibility for chasing full payment of the debt, and collecting the money when it comes in.
When the invoice is paid, the factor forwards the remaining balance on to the company, minus an agreed fee. Let’s take a closer look at each step in the process.
So, that’s how invoice factoring looks on paper. But how does it look in real life?
Case study #1 | Darlene
It’s the end of the month and the bills are due at Darlene’s small, Manhattan-based pizzeria. She has to pay her rates and her chefs’ wages, plus place new orders for drinks and ingredients. Money’s tight, and she’s still waiting to receive cash from an invoice for a big catering job she did for a function six weeks ago.
Darlene decides to bring in an invoice factoring company to help recover the $2,000 owed. The factor gives her 90% of the debt upfront, providing Darlene with $1,800 to ease her cash woes. Then, the factor chases payment of that invoice for her, freeing up Darlene’s schedule to grow her business.
When the gig pays up a few weeks later, the invoice factoring company takes a small cut (say, 3%, or $60) and sends Darlene the remaining $140.
Easy! But what fees are involved?
Invoice Factoring Costs
It’s important to remember that costs will vary across providers, and will also depend on things like your business’ size, type, and turnover. Commonly, though, you can expect to pay a mixture of the following:
A service fee
This is the price you pay to use the invoice finance facility, and it’s a percentage of your turnover. The service fee is calculated based on your invoice volume and customer base, and tends to differ greatly across providers. Larger businesses can negotiate a lower percentage, but it’s usually between 1% and 2.5% of your annual turnover. It’s charged monthly, and is kind of a ‘catch-all’ fee designed to cover the costs of keeping your account current.
A discount fee
This relates to the cost of factoring the invoice itself, and is similar to paying interest on a loan. The discount fee is calculated based on the value of the invoices you want to receive finance for. This fee is usually around 1% to 3% of the invoice’s value (in Darlene’s case, it was $60), and is applied to the cash advance you receive for your invoice.
A monthly minimum fee
A company may require you to factor a certain amount of invoices per month. If you don’t meet a pre-agreed minimum amount, you may be charged to make up the shortfall.
Benefits of Invoice Factoring
Invoice factoring is one of the quickest, most convenient forms of finance for SMBs that need fast cash. It’s also perfect for businesses that struggle with long wait times for payment, like recruitment agencies or construction companies.
As well quicker customer payments and protection from bad debt, invoice factoring can also lead to a boost in public perceptions of your company and, most importantly, in profits.
Let’s take a look at the benefits of invoice factoring:
✔ Improved cash flow
Collecting money can be a time-consuming process and when invoices aren’t being paid on time, cash flow issues are bound to arise. Invoice factoring provides a quick financial boost that helps prevent the issues associated with sluggish cash flow.
✔ More free time
Debt factoring essentially outsources the process of tracking payments, sending out statements and contacting those clients who are slow to pay up. With no need to worry about outstanding invoices, you and your team can focus on running your business instead.
✔ Increased potential profitability
For most businesses, investment is the key to profit. With invoice factoring offering a fluid option for improving your cash flow, you can invest more capital and meet your financial obligations, while avoiding the costs of late payment to suppliers.
✔ Better planning ability
If you don’t know when you’ll be paid, how can you plan ahead with any degree of accuracy? Invoice factoring offers a guaranteed cash influx, which is great news if your profits are reliant on reinvestment.
✔ Quicker customer payments
Invoice factoring specialists are professionals who are experienced in collecting payments, so customers are far more likely to settle invoices punctually with them. This level of professionalism can also have a positive effect on the way your company is perceived.
Invoice Factoring and Invoice Discounting Differences
While invoice factoring and invoice discounting are very similar, there are key differences – mainly relating to credit control. Do you want the responsibility of chasing payment of your unpaid invoices, or would you rather outsource it?
Find out which option is best for you below.
Invoice factoring vs invoice discounting
Invoice factoring involves the sale of your unpaid invoices to a third party factor. This factor then chases payment for you, and assumes responsibility for credit control, as well as receiving the payment.
Pros and cons of invoice factoring:
- Easier to get accepted for
- Credit control is taken care of for you, and can help boost perceptions of your business
- Provides an ongoing, highly scalable form of finance
- Most factoring facilities are whole turnover, meaning you may have to factor your whole sales ledger (unless you opt for selective invoice finance)
- Fees can be limiting and difficult to understand
Invoice discounting (also known as receivables discounting) also involves the ‘sale’ of your unpaid invoices to a third party to free up funds. However, unlike with a factoring deal, your clients won’t know that you’re receiving finance. You’ll still be responsible for collecting your own payments, and liaising with your clients to settle debts.
Pros and cons of invoice discounting:
- Usually less expensive than factoring, because you’re not paying for credit control
- Confidential – your clients won’t know you’re using third party finance
- You’ll need a higher turnover (around $100,000) to be eligible
Let’s take a look at another case study:
Case study #2 | Jennifer
Darlene’s cousin Jennifer runs a growing interior design agency, turning over around $120,000 a year. Like her sister, Jennifer also needs a fast cash injection to help fund an expansion to a new office in NYC – so she too looks to invoice finance.
Unlike her cousin, though, Jennifer is more of a ‘hands-on’ type. She’s happy to chase her own payments, and would prefer it if her customers were blissfully unaware that she’s receiving finance. Jennifer chooses invoice discounting to retain control over her sales ledger, and help maintain a handle on her client relationships.
Types of Invoice Factoring
Now that you’ve decided whether you’re more of a Darlene or a Jennifer, it’s time to think about whether you want an agreement with or without recourse. You can also opt for selective invoice finance for more flexibility, and to remain in full control of your sales ledger.
Alternatively, you might want to look at invoice factoring solutions that are tailored to the specific needs of your trade. The haulage industry offers freight factoring, a flexible form of finance for truckers, while there are plenty of companies offering specialist factoring for recruiters, too.
Let’s break down some of the industry jargon.
An invoice factoring deal with recourse means that you’ll remain liable for the debt. If your client becomes insolvent and can’t pay (or just won’t pay, for a prolonged period), then it’s bad news – you’re not getting the money back.
With no recourse
Agreements without recourse mean that responsibility of your unpaid invoices lies with the factor. It mitigates the financial loss for your business when your clients don’t pay up.
Of course, this kind of agreement doesn’t come cheap, and it’s not for everyone. But, if you have unreliable clients and don’t want to risk shouldering the brunt of bad debt, it’s almost certainly worth the extra outlay.
Selective invoice finance
Also known as spot factoring or single invoice discounting, this option is a more flexible form of invoice finance. Why? Because, rather than having to submit your whole sales ledger to be factored, you can factor just as few (or as many) invoices as you like.
In normal invoice factoring deals, you’ll have to sell your whole ledger – which, depending on the size of your business, could be hundreds (or even thousands!) of invoices. Obviously, this isn’t exactly ideal, especially if you’re a small business in need of a small sum of cash freed up in the short-term.
That’s where spot factoring comes in handy. By factoring a select amount of your invoices, you only get finance on what you need – not your whole ledger.
What is receivables financing?
‘Receivables’ refers to the amounts that are owed to a business, and are therefore considered to be assets. Receivables financing, then, is the overarching term for three forms of business finance:
- Factoring: As we’ve explored on this page, companies receive a cash advance on receivables (usually invoice factoring).
- Asset-based lending:Companies commit their receivables to a finance provider, and have limited control or flexibility around which assets are committed.
- Selective receivables finance: Companies have greater control over the assets that they choose to receive finance for.
What’s the difference between asset-based lending and invoice factoring?
Invoice factoring is a form of asset-based finance – your invoices are your assets, and you use them to get finance. However, asset-based lending – another form of asset-based finance – is different to factoring, and the two terms shouldn’t be used interchangeably.
In a factoring deal, your invoices are essentially ‘sold’ to a company for less than its value, in exchange for a quick injection of funds.
Asset-based lending, however, involves a loan that is secured using your company’s assets as collateral. While these can be invoices, they can also be other assets such as real estate, inventory, equipment, and raw materials.
So, while asset-based lending is more private, factoring is faster, more flexible, and comes without the risk of losing your company’s prized assets.