Published on 17 July 2024
Invoice factoring involves selling unpaid invoices to a third party in exchange for a cash advance.
It can be a useful way for businesses to access capital quickly to bridge cash flow shortages or cover unexpected expenses. In the right circumstances, it can be a good option for companies facing occasional and unanticipated cash flow issues or wanting to take advantage of unexpected business opportunities.
Summary
Key Takeaways
- Invoice factoring involves selling unpaid invoices to a third party.
- The factor issues a cash advance in exchange for the sale of the invoices.
- The factor then takes over the task of receiving the payment.
- When the debt is recovered, the factor settles the cost of the invoices, minus the cash advance and a fee.
Definition of invoice factoring
Invoice factoring is when a company sells some or all of its unpaid invoices to a third party, known as a “factor”, in exchange for a cash advance. This cash advance is typically 70% to 90% of the value of the money owed on the invoices.
That cash advance can then be used by the original company as it sees fit, for example to cover debts, buy materials or equipment, make new investments, or pay salaries.
The factoring company takes over responsibility for collecting the unpaid invoices. When the factor collects the money, the remainder is paid back to the original company, minus the agreed fees.
How invoice factoring works
Invoice factoring is a step-by-step process, beginning when an invoice is issued and ending when the issuer receives payment.
Step 1: Generating an invoice
Invoice factoring can only take place when a company generates an invoice. The invoice specifies the applicable payment terms.
Step 2: Selling the invoice
If a company wishes to unlock funds represented by an invoice before the due date, it can sell the invoice to a factor, releasing a proportion of the funds before the invoice is paid.
Step 3: Advance payment
In exchange for the unpaid invoice(s), the factor makes a cash advance against the value of the invoices. Typically, this is 80% to 90% of the value of the invoice.
Step 4: Collection by the factor
When the factor buys the invoices, they take over responsibility for collecting the payment. A factor differs from a debt collection agency in that a factor takes over responsibility for collecting payment for debts that are not yet overdue, while a debt collection agency chases overdue invoices in exchange for a fee.
Step 5: Remaining payment
When the factor receives payment, it then forwards the outstanding balance to the original company, along with any interest or late-payment fees that have been collected, but minus their own fees.
Example
A company sells an invoice worth $5,000 to a factoring company, in exchange for an 80% cash advance ($4,000). The factoring company then receives full payment from the customer. The factor then pays the original company the remaining 20%, minus a $500 factoring fee. In this case, the original company ends up with $4,500 of the initial $5,000 invoice.
Types of invoice factoring
Different types of invoice factoring can be used depending on the specific circumstances.
Recourse factoring
The most common type of invoice factoring is known as “recourse” factoring. Under recourse factoring, if the factor is unsuccessful in collecting an invoice, the original company is obliged to buy it back after a given period of time and remains ultimately responsible for any non-payment.
Non-recourse factoring
The alternative to recourse factoring is “non-recourse” factoring, where the factor assumes most, although not all, of the risk of non-payment. In non-recourse factoring, situations such as customer bankruptcy are usually specified and the company issuing the invoice remains responsible for non-payment. In most circumstances, factoring companies also restrict non-recourse factoring to invoices issued to customers with a good credit score.
Spot factoring
A small business may be quite comfortable managing invoices with regular clients for relatively small amounts but may be keen for a factoring company to take over responsibility for an unusually large invoice or invoices which represent a large proportion of the company’s annual turnover.
Spot factoring allows companies to decide which invoices to factor and which to continue to manage in-house.
Whole ledger factoring
In contrast to spot factoring, whole ledger factoring, also referred to as whole turnover factoring, involves selling all outstanding invoices rather than just a selection. It can be carried out on a regular basis.
Whole ledger factoring is an attractive solution for companies wanting to make the most out of an immediate cash advance, while other companies may enjoy the flexibility of picking and choosing which invoices to factor out and which to retain in-house.
Benefits of invoice factoring
Although invoice factoring is not suitable for all companies, there are certain recognized benefits which make it an attractive option for many.
Improved cash flow
The first benefit of invoice factoring is the additional cash flow which can be used to bridge short-term expenses, repay loans, or invest in unplanned business opportunities.
Reduced credit risk
The non-recourse factoring approach mentioned above eliminates the risk of non-collection, as the factoring company takes over the risk of non-payment. Factors always run credit checks on the end customer to minimize this risk.
Outsourcing collections
By selling their invoices, a company can free up resources to concentrate on its core business. The time and effort spent on collecting debt falls to the factoring company, reducing the resources that might otherwise have been spent on paying dedicated invoice collection staff and expertise.
Flexibility
Whether it be spot factoring or whole ledger factoring, invoice factoring can give companies additional flexibility when it comes to cash flow. Invoice factoring is also cheaper and easier than applying for a loan from a financial institution, making it a good option for covering short-term cash flow issues.
Costs and fees
Despite its recognized benefits, invoice factoring has its disadvantages. Although tracking payment becomes the responsibility of the factor, the factoring process itself involves certain administrative tasks. These will represent in-house costs which may vary depending on the complexity and scale of the factoring scheme. In addition, there are other costs associated with factoring.
Discount or factoring fee
The services of a factoring company come at a cost. A factoring fee or discount is a negotiable fee which the factoring company withholds from the value of the invoice when the invoices are sold. The value of the discount depends on factors including how long the factor anticipates it will take to recover the payment.
In most cases, the factoring discount will be up to 10% of the value of the invoice.
Service charges
In addition to the discount, additional service charges may also apply. These additional service charges may include application fees, invoice processing fees, monthly fees, and termination fees, all of which can add up.
Interest charges
In addition to service charges and discount fees, interest may also be applied to the value of the invoice. This will depend on how long the invoice remains unpaid.
Is invoice factoring right for your business?
Invoice factoring can be a great solution for companies needing to bridge short-term cash flow issues. It can free up time and energy spent tracking invoices and payment terms and allow you to focus on your core business. However, considerations such as the industry you are operating in, your customers’ credit history and payment behavior, and a full cost analysis should be considered before deciding if it is the right solution for you.
Conclusion
Invoice factoring can provide a short-term response to cash flow needs. But there is no one-case-fits-all solution to short-term cash flow issues, and you should carefully weigh up the advantages and disadvantages offered by invoice factoring.
If you are considering using invoice factoring, seek professional advice and calculate any additional fees to gauge whether it is the right solution for you.
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