Invoice factoring is a way for companies to unlock cash flow faster by selling their invoices to a third party at a discount. Unlike a business loan, invoice factoring helps businesses get paid faster with money that customers already owe to the business. Invoice factoring is typically provided by third-party lenders or independent finance providers (a factor or “factoring company”), but it can also be provided by banks.
When a business “factors” an invoice, it sells the unpaid invoice to a third-party factoring service. The factoring service “advances” the business a portion of the total invoice value (usually 70-90%) upfront and holds onto the rest. Once a customer pays the factoring company for the outstanding invoice, the factoring company deducts its fees and sends the remaining balance on the invoice to the business's bank account.
- A business sells goods or services to a customer.
- The business offers the customer net terms (e.g. 30, 60, or 90 days to pay). However, cash flow is tight and the business needs to be paid that cash sooner than the agreed upon net terms deadline.
- To access that cash faster, the business sells its unpaid invoice to an invoice factoring company.
- The factoring company will check the customer's credit score and verify the customer's creditworthiness. Once everything checks out, the factoring company will advance the business a portion of the total invoice amount (usually 70-90%).
- This way, the business gets money in its bank account faster. And the customer gets 30, 60, or 90 days to pay the factoring company for the full invoice.
- Once the customer pays the full invoice amount to the factoring company, the factoring company will pay the remaining portion of the invoice (10-30%) to the business minus all factoring fees.
Factoring fees typically range from 1-5% per invoice. At face value, that might seem like a bargain. However, factoring costs can also include processing fees, application fees, monthly minimum fees, and other payment terms hidden in the fine print. So it can be difficult to calculate how much invoice factoring costs your business over time.
For example, let’s say you factor a $10,000 invoice and your customer takes four weeks to pay. A factoring service would pay you 80% of the invoice upfront (an $8,000 cash advance) and hold onto 20% of the invoice (a $2000 reserve) until the client pays the invoice.
The total cost of factoring that invoice could include any of the following fees:
- A flat-fee factor rate. A 4% flat-fee factor rate works out to $400.
- A per-week fee to factor that invoice. A 2% factor rate works out to $400 per week until your customer pays up.
- Processing fees. A 3% processing fee is $300.
- Payment fees. Want to receive your cash advances from the invoice factoring service via ACH? There are fees for that, too.
When you add up a 3% processing fee ($300), a 2% per-week factor rate ($200 x 4 weeks = $800), ACH payment fees ($10), you’d end up paying $1110 in factoring fees in this scenario—meaning you’d be losing out on a whopping 11% of the invoice’s total value.
Factoring fees aren’t standardized. Factoring service fees can be higher if your customers are deemed “high risk” or take longer to pay. So do your research, read the fine print, and make sure you know the true impact that invoice factoring will have on your business's bank account and bottom line before you sign up with a factoring service.
To qualify for invoice factoring, a business generally needs to meet the following criteria:
- Commercial invoices. Because factoring requires the sale of invoices to commercial Factored invoices must be commercial, meaning that consumer-based invoices generally won’t qualify for invoice factoring.
- B2B or B2G. The business must work with business-to-business (B2B) or business-to-government (B2G) customers.
- Creditworthy customers. The business’s customers must be creditworthy. Customer credit checks and customer creditworthiness are determined by the factor.
- Minimum monthly volume. The business must generate a certain amount of revenue in invoices per month to qualify for invoice factoring. Minimums are set by the factoring company and vary from factoring service to service.
Because of how factoring works, invoice factoring tends to be more suited to certain types of businesses and not-so-great for others.
Here are the industries that commonly use invoice factoring:
- Technology and IT
- HR & staffing
- Government contractors
Invoice factoring is a helpful short-term solution for cash-flow emergencies, but the cons almost always outweigh the pros. Compare the advantages and disadvantages of invoice factoring before you move ahead with this financing solution.
- Faster payments. Invoice factoring can help a business access working capital faster. Speeding up payments can help businesses cover cash-flow gaps caused by net terms and slow-paying customers.
- Sustainable ongoing cash flow. If you need to float net-terms to your customers and stay competitive in your industry, but you can’t afford to wait 90 days for an invoice to be paid, invoice factoring can help you bridge that gap.
- Easier than getting a business loan. Factoring companies care more about the creditworthiness of your customers and the value of the invoices you want to factor than they do about your business’s operating history or credit rating.
- No collateral required. Invoice factoring is typically unsecured financing, which means that a business doesn’t require collateral (e.g. real estate, inventory) that the lender could seize if you can’t cover debt from unpaid customer invoices.
- Better chance of your business surviving. Steady, faster cash flow can have a huge impact on a business’s ability to stay afloat, drive sales, and sustain growth.
- Loss of control. With invoice factoring, businesses give up control over payment collection to another company. Customers no longer send payments to the business. Instead, they send them to the factor. How well the factor handles payment collections (think customer service) can impact your business relationships.
- Red flag to your customers. Using a factor can also send a negative message to customers that your business is struggling. If invoice factoring gives the impression that your company is weak or that it might be going out of business soon, customers will work with your competitors to strengthen their supply chain and reduce risk.
- It's time-consuming. Factoring services have an invoice-by-invoice application process. Which means you need to upload every single invoice you'd like to factor and wait for a decision from the factoring service each time you want to know your approved advance rate and get paid faster on a net terms invoice. This might be okay if your invoicing volume is low. But when you invoicing hundreds of customers a month, the process doesn't scale well.
- Monthly minimums. 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.
- Huge fees. Factoring fees are high. And hidden costs like processing fees, payment fees, administrative fees, interest, and late payment penalties can all add up to make invoice factoring an extremely expensive endeavor.
- Costs even more if customers are risky. Factoring company fees will be higher if a factor determines that your customers are “high risk” (this usually happens if a customer has a low credit score or bad credit history). Late customer payments or delinquent payment history can also increase factoring fees if you use recourse factoring.
- Doesn’t work for every business. Invoice factoring can help B2B and B2G businesses. It doesn’t work for businesses that sell directly to consumers (B2C).
- It’s risky if your customers don’t pay. If your customer fails to pay for an invoice, recourse factoring companies will require you to buy back the unpaid invoice and cover the debt yourself.
Companies use invoice factoring to solve short-term cash-flow issues. Faster access to working capital can have a huge impact on a business’s ability to survive. And the immediate cash injection that invoice factoring provides can be exactly what a struggling company needs to remain operational.
However, companies typically stop using invoice factoring once that immediate cash-flow problem is solved. So if a business is using invoice factoring as standard practice, it usually indicates that there’s a systemic issue in the company. Invoice net terms, inventories, or accounts receivable processes likely need to be adjusted to stabilize cash flow and ensure that the company has enough money to operate.
Who should use invoice factoring? Every company is different, so there’s no one-size-fits-all answer to this question. If you're a business owner trying to decide if invoice factoring is a smart move, you’ll need to do the math to determine if the benefits of using invoice factoring outweigh the downsides and higher fees.
Here are some scenarios where invoice factoring can be helpful to a business.
If your business is running out of cash while waiting for customer payments, invoice factoring can help you get your accounts receivable cycle under control.
Taking advantage of an unexpected opportunity is another reason to use invoice factoring. In this scenario, your business cash flow is fine but cash on hand and other financing options aren’t enough to take advantage of a growth opportunity. If the cost of invoice factoring is less than the return on the opportunity, then invoice factoring could be one of your better financing options.
Invoice factoring can also help businesses grow. New projects and hiring of talent are all costly endeavors but can be necessary to take a business to the next level.
Collecting payment on invoices can be time-consuming. Some companies have a department dedicated to this task, but that comes with huge overhead costs and an administrative burden. When you factor an invoice, the factoring company will handle payment collection.
The world of factoring is full of jargon. Use this glossary of terms to learn about the types of invoice factoring and other common lingo.
Accounts receivable factoring is another name for invoice factoring.
CHOCC is an acronym that stands for “Client Handles Own Credit Control.” With CHOCC factoring, the business is in charge of collecting payments for each factored invoice (rather than the factoring company taking care of it).
Confidential factoring is a form of invoice factoring where customers are not told that they are paying invoices to a factoring business.
Debt factoring is another name for invoice factoring.
Disbursements is a name for all of the additional administrative fees that a factoring company may charge—application fees, transaction fees, credit checks, payment fees, and more.
Disclosed factoring is the typical type of invoice factoring, where your customers are aware they're dealing with a factoring business.
Flat fee factoring is when a factoring company and their client agree on a set, fixed fee for each invoice that the factoring company is going to factor that pays within 90 days.
Freight bill factoring is a specific type of factoring for the freight and trucking industry. Similar to traditional factoring, a trucking company can use freight bill factoring to get advanced cash faster; when the trucking company delivers the goods to a customer, it submits the bill of lading to the factoring company who advances an agreed portion of the invoice value.
Non-recourse factoring is when the invoice factoring company fully assumes the risk of non-payment. If one of your customers fails to pay an invoice, your business won’t be liable to pay back the outstanding debt. Non-recourse factoring fees are generally higher due to the additional risk that the factor is taking on.
Recourse factoring is when your company is liable for any unpaid invoices—bad debts are charged back to your business. Most invoice factoring services work on a recourse factoring basis. Recourse factoring fees are generally cheaper than non-recourse factoring fees.
Selective factoring gives businesses the opportunity to factor individual invoices or small bundles of invoices, rather than factoring their entire sales ledger.
Spot factoring is another name for “selective factoring.” With spot factoring, businesses can factor individual or small bundles of invoices.
Whether you're running a small business or a large enterprise, invoice factoring isn’t suitable for every business. If you want to leverage the benefits of any business financing solution while avoiding the pitfalls, researching your options, doing your due diligence, and choosing the right business financing solution for your particular situation is key.
If invoice factoring seems risky or not-quite-right for your business, you can explore some alternatives to invoice factoring like Resolve Pay, invoice financing, business loans, cash advances, or a line of credit.
Invoice factoring can get your business out of hot water in the short-term. But it can have a negative impact on your business in the long run.
Resolve Pay is better than invoice factoring if you need to unlock cash flow faster, extend net terms to your customers, and drive growth with more working capital for less fees.
Ready to find out how to improve your credit processes and grow your business with risk-free net terms? We offer a free credit report and financial information as part of a free trial. Request a demo with our team to find out more.