Often known as ‘debt factoring’ or ‘factoring’, invoice factoring is a product that allows companies to sell their unpaid invoices (also known as accounts receivable) to a third-party factor. This third-party factoring company purchases the unpaid invoices for a denoted percentage of their total value and is thereafter responsible for collecting the payments. Invoice factoring is increasingly growing in popularity as a method of alternative business funding. The reason for its increased popularity is due to the fact that is has become more difficult for companies that have imperfect credit scores to make use of typical financial products from main high street and commercial banks. Invoice factoring is created so as to provide working capital to companies who typically experience longer payment terms from their clients with invoices.
The invoice factoring process
A majority of third-party factoring companies pay in two batches – the first which covers the bulk of the account receivables (around 80% but this amount can vary) and the second when the client in question finally settles their invoice (around 20%), minus any sort of factoring fee. These ratios will differ according to your assessed aspects. Dividing the payments into two instalments also ensures it fulfils a need for instant cash flow via the first payment.
The steps are typically as follows:
- First, your business submits invoices to the third-party factoring business in order to determine if you are a candidate. They will then assess the risk factor of the loan and provide you with a quote.
- Once you have reached an agreement, the factor will pay the first instalment.
- Thereafter, the factor will begin collection of the unpaid invoices from your customers. Once this has been completed, you will be rebated the remaining balance, minus the fee of the factor.
Why is invoice factoring useful?
Simply put, invoice factoring speeds up access to funds and incoming flow of cash, considering the process of receiving payments for invoices can be a somewhat lengthy process. Payment terms for invoices can be anywhere from 30 to 120 days, meaning the payment can be delayed by up to 120 days. This means there will be a gap in cash flow during this period, which may be filled by loans or overdrafts. As a more constructive way to fill this gap, alternative finance such as invoice factoring can add value to business in a time where you need it the most. Note, however, that if your business has an imperfect credit score, particular types of financial products might not be available.
Advantages of invoice factoring
- It can reduce the amount of time spent on administration, as well as chasing late payments as the factor takes over responsibility for collecting debt and taking over the management of your company’s credit control.
- It is also a quick source of cash flow by making use of working capital that is held in unpaid invoices.
- Invoice factoring can grant better cash flow control for your business where you may have different types of credit terms for your customers.
- Factoring amounts can easily be expanded and contracted. It is also less expensive that resorting to equity investors.
- Third-party factoring companies are experienced and professional debt collectors. Using them can improve your clients’ payment times over a longer period of time.
Disadvantages of invoice factoring
- The costs of invoice factoring are more than an average bank loan, meaning this kind of financing works better for companies that have a higher profit margin on order to absorb the costs.
- Invoice factoring could run the risk of affecting customer relations, as you are required to inform them if a third-party business is involved in collecting your invoices.
- By handing over responsibility to a third-party, your business is essentially giving up an element of control.
Is invoice factoring for any business?
This product is just as fruitful for smaller companies and start-up businesses as it is for larger corporations.
The following are factors that companies will explore when assessing eligibility:
- Time frame
- Potential risk
- Size of invoices
- Origin of invoices
- Your company’s credit score, as well as reputation
Any business, including a brand-new company, start-up and even a company with poor credit, can benefit from invoice financing. It is a means of obtaining finance in a more effective manner. However, note that the rates might be slightly higher for businesses that are less established or have a bad credit score.
Cost of invoice factoring
How much you will end up paying for invoice factoring for your company depends on a variety of aspects, including the size of your business (small business or larger corporation); the value of the invoices and the level of potential risk for the third-party factor partner. Factoring fees will vary across the market. Costs are combined into a total service charge and factoring fee, however, there could also be additional charges for protecting your credit or making the choice to end factoring service early. On average, a third-party factor charges between 1.5 and 5% of the value of your factored invoices per month.
Invoice finance and factoring: what is the difference?
The term ‘invoice finance’ relates generally to the accounts receivable financial sector. Along with discounting, factoring is a type of asset-based financial product that falls under the ‘invoice factoring’ umbrella.
Invoice factoring and discounting: what is the difference?
The main difference between these two terms is that invoice discounting enables a company to retain some sort of control over its sales ledger and collection of invoices, however, invoice factoring delegates this role to the financial provider in question.
Invoice factors contact customers directly in order to settle invoices. Some business owners might be worried that having a factor take over credit control on their behalf could affect their client relationships. However, note that some factoring parties and companies actually have little contact with your customers and debtors. For example, a third-party factor could provide the service of setting up a separate bank account for your client under your business name.
Selective invoice factoring
This is also known as selective invoice discounting, single invoice financing or spot factoring. The process enables you to choose which invoices you want to factor for your business by selling particular invoices, giving you an element of flexibility.
Also known as supply chain financing, reverse factoring is another financial solution, which is typically initiated by a larger business introducing a smaller company to its provider of invoice financing. The smaller business’ invoices are secured against the higher value invoices for the larger company, therefore it becomes a case of the bigger one lending financial security to the smaller business, securing its supply chain as well.
A fairly standard practice, recourse factoring means it is your responsibility to cover the cost if your client does not pay their invoice. Non-recourse factoring is sometimes referred to by factors as being bad debt protection, which protects your company in the event that you have non-payments. In some instances, it may be warranted but it does come with higher costs due to an increased risk factor.
Invoice factoring regulation in the UK
Currently, the industry of invoice financing is not regulated by the FCA (Financial Conduct Authority) in the UK, therefore, it is your responsibility to exercise caution when selecting a provider with whom to work. Investigate any hidden fees that could arise, especially ones that may not be immediately visible or payable. It is also worth noting that if this industry becomes regulated in the future, it will almost definitely increase factoring costs, which would be passed onto customers.
Applying for invoice factoring for your business
There are a variety of different resources available online or in person to access platforms where you can apply for an invoice factoring quote for your business. Here, you can select if you would like to factor your invoices separately (selective invoice factoring) or on an ongoing basis.
Is invoice factoring a good idea for your company?
It depends on your particular business, along with your profit margins and the number of unpaid invoices you would consider factoring. Invoice factoring does, however, work well if a company has high profit margins and fewer invoices.
Can I obtain invoice factoring services from high street banks?
Most commonly used banks do offer invoice factoring, however, they are naturally overly cautious about taking on new companies as customers outside of their existing business clients as they could be high risk.