Invoice Factoring: All You Need to Know

Table of Contents

What factoring is, how it works, costs, and much more valuable information

We hope this complete reference helps you understand invoice factoring thoroughly. If, after finishing reading, you still find yourself with questions, please get in touch with us. We would love to help.

What is Invoice Factoring?

Invoice factoring and invoice financing are often used interchangeably and, therefore, mistaken for the same thing. They are not! Invoice factoring is the sale of an asset. Invoice financing (or receivable financing) is a business loan that uses unpaid invoices as collateral.

How Does Invoice Factoring Work?

The invoice factoring process consists of four main components:

Your business
Your clients (debtors)
One or more outstanding invoices
A factoring company (the factor)

The factoring process involves seven steps:

Step 1: Your business sells to another business and issues invoices due in 30 to 90 days.
Step 2: You set up an account with a factor.
Step 3: You submit your outstanding invoices to the factor.
The factor provides an immediate cash advance based on an agreed percentage.
Step 5: The debtor pays the invoice.
Step 6: The payment is deposited into a temporary reserve account.
Step 7: The factor deducts the fees and amount advanced and wires the balance to your bank account.

how does factoring work - factoring process

Invoice factoring example

Your business delivers product XYZ to Wholesale Inc., issues an invoice for $1,000, and gives the debtor 60 days to pay.
You sign an agreement with an invoice factoring company as follows: 80% advance rate and 2% discount fee every 30 days
You sell the outstanding invoice to the factor and receive an advance of $800.
On day 29 the debtor sends a check to a lockbox opened by the factor under your name.
The invoice factoring company receives the money and deposits it into a reserve account.
The factor takes $20 as a factoring fee, deducts the funds already advanced to you ($800), and sends you the $180 remaining balance (sometimes called a rebate).

How can business owners be eligible for factoring?

Factoring is an accessible working capital solution for growing startups, small businesses, and established organizations that sell to creditworthy customers on credit.

Big and small businesses in these industries use factoring as a source of capital (but not limited to) :

Staffing
Trucking & Freight
Transportation
Construction
Manufacturing
Distribution
Apparel
Security Guards
Commercial Service Providers
And many others…

Potential reasons for accessing factoring financing:

You need temporary cash flow for ongoing expenses, payroll, and other vendor bills.
You cannot get working capital from a financial institution.
You need cash flow to complement your current financing.
You choose to avoid adding debt to your ledger.

Factoring clients typically share one or more of the following characteristics:

Insufficient credit history or bad credit scores
Troubled past, including prior bankruptcies or forbearance
Credit denied or maxed out
Small businesses with rapid growth
Operating losses
Negative net worth
Highly leveraged
Delinquent taxes
Lack of collateral

Advantages and Disadvantages of Using Invoice Factoring

Pros

Quick cash flow boost
You can give terms to your customers without worries
Low qualification requirements and a simple application process
High approval ratio
Cash flow without debt
No collateral or personal guarantees are required
Minimal credit score requirements
Operational support to A/R department
It is much cheaper than invoice financing

Cons

Not accessible to B2C (those that work only with consumers)
More expensive than traditional business financing
Requires ceding some control of client interactions regarding A/R
Not a solution for unpaid invoices that are late or delinquent
Liability for non-creditworthy customers (in most cases)

Bank Financing vs. Invoice Factoring

If you cannot get an inexpensive business loan or want to avoid adding more debt to your ledgers, factoring may be the best answer when you experience cash flow shortages.

Invoice Factoring vs Invoice Financing

This is the most important piece of information that you need to consider when you compare factoring with invoice financing:

Factoring is a sale transaction.
Invoice financing is a business loan.

You’ll find two types of invoice financing offers:

Receivable financing offered by traditional renowned banks
Invoice financing by online lenders

The first type is similar to a traditional bank loan and much cheaper than the second choice. This type of finance has high approval conditions and requires your business to have an excellent financial background and credit score. If you can qualify, ask your banker about the details.

The second one is offered all over the web by lenders that want you to confuse factoring with their “invoice financing” offer. They are highly accessible and risky business loans mainly marketed to small businesses with periodic installments. They use your receivables as an excuse to lend you expensive capital, but they don’t care if your customer can pay.

Be aware! Many small businesses fall for these receivable financing offers and lose all their margins to cover interest charges.

Please check this article if you want to learn more about these invoice finance businesses.

How Do Companies Qualify For Factoring??

The basic invoice factoring requirements:

Your business is selling products or services to other businesses or the government.
Your company’s annual revenue exceeds $50,000.
Your clients are expected to pay in 30 to 90 days.
Your clients are creditworthy.

Qualification requirements vary between different invoice factoring companies. Feel free to read our article about Invoice Factoring Requirements for other potential criteria.

How Much Cash Will You Get Upfront?

According to the clauses of your factoring agreement, your advance percentage typically ranges between 75 and 90 percent of the receivables face value. Multiply the advance percentage by the receivable value to calculate how much funding you’ll get upfront. For example, if your discount is 80 percent and you factor a $2,000 unpaid invoice, you’ll receive a lump sum of $1,600. Please read "What factoring advance can you get?" to understand how invoice factoring companies determine your advance percentage.

Remember, this is not all the funding that you’ll get. The remaining invoice amount minus the factoring fees is “rebated or released” when your customer pays.

The Costs of Invoice Factoring

Most factors use one of the following discount rate structures to calculate fees:

A flat discount
A combination of a flat discount and PRIME plus Margin

To learn more, read “How much does factoring cost?”

Other Typical Factoring Contract Provisions

In addition to service fees, most invoice factoring agreements also include the following stipulations:

Recourse or Non-recourse Factoring

Recourse factoring protects the factor when receivables become delinquent, requiring you to repay the money advanced.

Also, it usually requires that you have credit insurance to cover the factor’s risk of potential delinquency. Your customers need to be highly creditworthy to be approved by the insurance agency.

For a more detailed explanation of these alternatives, please check out “Non-recourse versus recourse factoring arrangements”.

Invoice Factoring Minimums - How many invoices do you need to factor?

Most invoice factoring contracts require a monthly minimum to be factored because the fewer the invoices, the higher the operational expenses will be for the invoice factoring company. Typically, these minimums are established at the beginning of the relationship, considering highly achievable targets. A higher minimum should lower the offered invoice factoring discount.

Author: Marc J Marin