Invoice factoring is a financing option where you sell some or all of your outstanding invoices, or accounts receivable, to a third-party to improve your cash flow. The third-party factor will charge a fee, also known as a discount, for providing the service.
By converting these receivables to cash, you get cash sooner than standard payment terms (such as 30 days, 60 days or 90 days) from products and services you have already sold. This is especially valuable to a small business, which can use this cash in many ways:
- To pay bills faster
- Cover seasonal cash flow constraints, business expenses or liabilities
- Control exposure to bad debt
How Invoice Factoring Works
In a typical business-to-business transaction, payment terms can be 30 days, 60 days, 90 days or longer. The longer the payment term, the longer it will take your business to have working capital to run your business.
By factoring invoices, you get revenues immediately.
To begin, you simply sell your outstanding invoices to a factoring company in return for a lump sum payment. These payments can range between 50 to 90 percent of the invoice total. You get the balance due (less the factoring fee—often a percentage of the invoice amount) once all the invoices have been paid.
You can deposit these funds into your bank account and use them immediately for working capital. That’s much quicker than the 30- to 90-day payment terms that are typically associated with a business-to-business transaction.
Invoice Factoring vs. Invoice Financing
While factoring an invoice is similar to a loan, there is no collateral tied to the funds. The factoring company owns the invoices and gets paid when it collects from your customers.
In most cases the factoring company will pay you most of the invoiced amount immediately, then collect payment from your customers. Often, you will receive a final payment once your customers have paid their invoices to the factoring company.
With invoice financing, your invoices serve as collateral to get a cash advance. You are responsible for collecting payment on the invoices, and you make regular payments to the lender on the loan or cash advance.
Both invoice factoring and invoice financing can help improve your cash flow. The best option depends upon several variables. If you are comfortable managing collections of outstanding invoices, invoice financing might be the best choice. If you would rather avoid contacting customers about what they owe you, invoice factoring would be a better option.
Recourse vs Non-recourse Factoring
There are two main kinds of invoice factoring based upon the amount of risk the factor will assume.
Recourse factoring: you are responsible for buying back any invoices that don’t get paid to the factoring company. This is the most common type of factoring, limiting risk to the factor.
Non-recourse factoring: the factoring company assumes most of the risk from customers that don’t pay their invoices. Terms can vary with non-recourse factoring, as few factoring companies will assume all the risk from uncollected payments.
A non-recourse factoring agreement may include language that specifically calls out situations where the factor is, and is not, responsible for uncollected payments. Examples include:
- Offering non-recourse factoring only if a debtor declares bankruptcy
- Limiting non-recourse agreements to debtors with good credit ratings
- Conversely, excluding debtors with bad credits ratings in non-recourse agreements
Candidates for Invoice Factoring
Any company that sells products with payment terms could be a candidate for invoice factoring. These could range from a small business or start-up to a large publicly traded company in many different industries: office supplies-furniture, food and beverage, fashion, accessories, footwear, and consumer technology to name a few.
Here are some reasons you might consider invoice factoring:
- Need revenue immediately to run your business
- Cover an unexpected expense
- Purchase additional inventory, equipment or other major business investment
- Keep customers on standard payment terms while improving your cash flow
- Address delays in recognizing revenues from slow-paying customers
- Outsource your collections and receivables management to reduce overhead and simplify operations
- Outsource accounts receivable bookkeeping
- Review customer orders to assess their creditworthiness
Benefits of Invoice Factoring
Immediate access to cash
When applying for a bank loan, it can take months to get approved, then additional time to receive the funds upon approval. With invoice factoring, you get access to cash quickly, typically in days or, in some cases, the same day.
Instead of assessing your loan application based upon collateral, credit score, ability to repay the loan or limited credit history, a factoring company will base its decision on your customer’s payment history. That determines the level of risk they are assuming from the investment.
Outsource accounts receivable activities
The factoring company is usually responsible for tracking and collecting outstanding invoices and dealing with late-paying customers. That leaves you more time to focus on business operations that have a direct impact on revenues, cost reduction, and customer support.
No Collateral Required
Like a credit card, invoice factoring is often unsecured financing. With no collateral required to obtain the financing, your real estate, inventory, or other business assets are not at risk if the invoices don’t get paid.
Improved Customer Relationships
By letting a factoring company handle collection calls for you, you avoid conversations about payment status. Instead, you can focus your communication on customer service and maintaining good customer relationships.
Disadvantages of Invoice Factoring
The fees associated with this type of financing can be higher than more traditional financing. Typically, a factoring company will charge between one and five percent of the total invoice amount.
Potential additional costs:
- Application and credit check fees
- Invoice processing charges
- Late payment fees
A certain volume of late payments could also trigger an increase in fees or interest rate.
Because it limits the risk, recourse factoring can be less costly than non-recourse factoring. In any case, you should examine the tradeoffs between cost and risk management before committing to invoice factoring.
Dependency on Customers
Invoice factoring companies will examine the payment history and creditworthiness of your customers. That will determine how much risk is involved in this financing. With a large number of late-paying customers, your costs for invoice factoring could increase or the factor may choose not to work with you.
Here are some other customer issues relating to invoice factoring:
Lack of control
Invoice factoring involves handing over complete control of your invoices to a third party. As a business owner, you may not want another company to act on your behalf and potentially disrupt a long-term business relationship.
No guarantee of collection
The factoring company may not collect on all your unpaid invoices. As stated earlier, if you are working with a recourse factor, the factoring company may require you to buy back the unpaid invoice or replace it with one of equal or greater value.
Business-to-business commerce focus
Invoice factoring is a consideration for businesses that work with other businesses, where transactions involve invoices with payment terms. Businesses that sell or work directly with consumers won’t qualify for this type of financing.
Responsibility for collections
It’s important to clarify who is responsible for collecting unpaid invoices as part of recourse and non-recourse agreements. Some invoice factoring companies may not serve as collections agencies or follow up on collections with late paying customers.
Example of Invoice Factoring
Consider a small business selling office furniture, with dozens of outstanding invoices across multiple customers. Total accounts receivable come to $100,000. These customers have payment terms ranging from 30 to 60 days, but you need the cash right away to cover expenses.
The factoring company could agree to purchase the invoices for a 3% factoring fee, or $3,000. It might pay you 85% of the value of these invoices, or $85,000, in a few days. When the company has collected payments for all the invoices, it will remit the remaining balance due, less the 3% fee.
If you have a recourse contract and the customer doesn’t pay:
- You may have to buy back the unpaid receivable from the factoring company or replace it with another current receivable of equal or greater value.
If you have a nonrecourse contract:
- You’re under no obligation to repay or replace the unpaid receivables. In this case, you’ll likely be charged a higher transaction fee.
In the real world, invoice factoring contracts may be more complex. That’s especially true for recourse factoring agreements, where multiple fees could result when customer don’t pay their invoices.
Alternatives to Invoice Factoring
Supply Chain Finance – Invoice Factoring 2.0
Alternative financing methods besides invoice factoring include supply chain finance and PO financing. Both are designed to help businesses where incoming revenues aren’t keeping up with sales.
Supply chain finance removes much of the financing risk. It allows you to assume the credit profile of the customer you’re doing business with.
With supply chain finance, your customer shares information about an approved invoice with a financial institution, often the buyer’s bank. This lowers the investment risk. If the buyer is a large company with a better credit rating or has access to a larger line of credit, you get the benefit.
That can dramatically lower your interest rate and related fees associated with this financing. Furthermore, you can benefit from both a low interest rate environment and a new benchmark for this type of financing.
For years, the benchmark lending rate has been the U.S. dollar London Inter-Bank Offered Rate, also known as LIBOR. In 2017, a new lending benchmark has emerged: the Secured Overnight Financing Rate, or SOFR. With SOFR, US Treasury bonds are posted as collateral, lowering the financing risk and potentially business financing rates.
While supply chain finance has not yet achieved the same levels of acceptance as invoice factoring, it is a financing option you should discuss with customers that offer it.
Yet another business financing option involves purchase order or PO financing.
As it implies, PO financing involves financing against the purchase order—a commercial document given by buyers to sellers that authorizes the purchase. The PO is generated at the start of a transaction before you could generate an invoice that could be factored.
Here are some examples where PO financing may be considered:
- For a large order that has a narrow timeline for production and delivery
- When you don’t have the capital to fulfill an order
- For negotiating discounts on the purchase of raw materials with advance payments
- For operating capital during the time period where the product has been produced but shipping has been delayed
Benefits of P.O. financing include the following:
- Access to working capital to pursue a lucrative sales opportunity
- Ability to manage new and recurring orders that could place a strain on business operations and cash flow
- Expedite the import of raw materials and export of orders
- Strengthen customer and supplier relationships as you grow your business
Invoice factoring and other alternative financing options such as PO financing and supply chain finance can help you improve your cash flow and get timely funding for ongoing business operations. Assess each option and compare them to other conventional funding options to determine the best business financing approach for you.