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 80% 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.
You can also be interested in...
How to Forecast Cash Flow: A Practical Guide & Example for B2B Businesses
Learn how to create an accurate cash flow forecast, manage accounts receivable risk, and ensure B2B financial health. Discover key steps, examples, and expert insights from Allianz Trade.
More information
How to Prevent and Solve Cash Flow Problems
Effective cash flow management is critical for every business, especially small businesses, as it ensures the smooth running of operations, timely payment of salaries and bills, and supports growth investments. However, no business is immune to unexpected cash flow problems, whether caused by late payments, customer insolvency, or unprofitable investments.
More information
Cash Flow Management: Definition, Benefits, and Proven Strategies
Effective cash flow management is critical to business survival and growth. It involves carefully monitoring, analyzing, and optimizing the cash inflows and outflows of your business to maintain financial stability, prevent liquidity crises, and capitalize on opportunities for growth.
Read the article
What are disputed invoices and how can they be resolved?
An invoice is considered to be disputed when a customer may disagree with the invoice and may refuse to pay
More information
Working Capital Requirement or WCR
The working capital requirement is a key indicator of the financial resources you’ll need before seizing new opportunities. Learn more.
Read the article
What is good working capital ratio
The working capital ratio is a key liquidity indicator to know before launching new activities. Find out more.
More information
How to protect your cash flow from late payers
Discover six effective strategies to safeguard your business from cash flow disruptions caused by late or non-paying buyers. Allianz Trade helps you to identify early warning signs of distressed buyers and explore varying levels of protection against bad debt.
More information
12 Ways Your Business Can Improve Cash Flow
Keeping a close eye on your cash flow is the key to growing a successful business. Allianz Trade shares 12 tips to help you improve your cash flow.
More information
What is invoice financing and how does it work?
Is invoice financing an interesting option for your business? What are its benefits? Read the article to find out.
More information
Trade credit insurance: find the right provider
How to choose your trade credit insurance provider for an efficient credit control policy? Check out our tips to insure against bad debts.
More information
How Trade Credit Insurance Secures Your Cash Flow
Trade credit is a powerful tool that can in turn weigh on your cash flow. Discover how trade credit insurance covers this risk.
More information
Our expertise and commitment
Allianz Trade is the global leader in trade credit insurance and credit management, offering tailored solutions to mitigate the risks associated with bad debt, thereby ensuring the financial stability of businesses. Our products and services help companies with risk management, cash flow management, accounts receivables protection, Surety bonds, business fraud Insurance, debt collection processes and e-commerce credit insurance ensuring the financial resilience for our client’s businesses. Our expertise in risk mitigation and finance positions us as trusted advisors, enabling businesses aspiring for global success to expand into international markets with confidence.
Our business is built on supporting relationships between people and organizations, relationships that extend across frontiers of all kinds - geographical, financial, industrial, and more. We are constantly aware that our work has an impact on the communities we serve and that we have a duty to help and support others. At Allianz Trade, we are strongly committed to fairness for all without discrimination, among our own people and in our many relationships with those outside our business.
