In-Depth Guide on Invoice Factoring

Looking forward to receiving payment from your customers for your outstanding invoices? We’ve got your back. Invoice Factoring can be helpful. 

There is a general understanding that invoices are set to payment terms of 30 to 90 days, which means that you can expect to not receive it for at least a month after the invoice is sent to your client, if not longer. According to reports, the invoice factoring market size surpassed $3 billion in 2022.

Small business owners are often put in a constant cash crunch due to these long payment cycles, making it difficult for them to keep up with necessary expenses like salaries, utilities, or inventory due to their long payment cycles. 

Such expenditures prevent you from investing, allowing you to grow your business or keep your day-to-day operations running smoothly.

In this guide, you will learn what invoice factoring means, how it works, and its advantages and disadvantages.

Invoice Factoring (Meaning & Example)

The invoice factoring process is when a business owner sells invoices to an invoice factoring company in exchange for an advance of cash. 

Factoring companies don’t only provide services, such as purchasing invoices; they also pay cash advances on the invoices they purchase and perform collection duties for the invoices they purchase. 

A factoring company is often involved in asset-based lending, such as financing accounts receivable and other commercial lendings.

Unpaid invoices typically generate 70 to 90 percent of factoring advances. A factoring company collects a fee from the invoice payment, then sends you the remainder. Choosing a factoring company is whether you’re looking for a one-off sale or want to build a long-term relationship. 

Let’s take an example of how the factoring company process works regarding unpaid invoices. Denila is a small business owner. There was an invoice issued by her a few months ago for $20,000 with a payment term of 30 days, as stated on the invoice. The entire amount of her invoice was supposed to be paid by her customer three days before the deadline and not wait until the last minute. In the meantime, her supplier was offering a discount if she ordered raw materials in bulk, but the offer was only available for a limited time, so she decided to take advantage of it while she waited for the customer to pay. 

The discount was not available to her due to her lack of funds. It affected her expenses and cash flow to wait for her customer to pay the invoice. Trying invoice factoring companies improved her cash flow.

With an invoice factoring company, she issues the same invoice for $20,000. Typically, factoring companies provide advances of 80-90% (80% or $16,000). Invoices are paid within 30 days of receipt.

4% of the balance is deducted as a service fee or $800. Denial receives $19,200 in total. Although she did not receive the entire invoice amount, she was given an advance immediately. In other words, she did not have to wait for her cash flow.

To issue the invoice, you can employ invoicing software like InvoiceOwl that lets you generate an invoice in a matter of minutes. To begin with, you can try free trial and access its premium features that give you more than just generating invoices.

Benefits & Pitfalls of Invoice Factoring

Just like anything and everything comes with benefits and pitfalls, and invoice factoring is no different. Let’s get started now. 

Advantages of Invoice Factoring

A business may consider an invoice factoring company for various reasons. The following are five of the most important:

• A fast cash receipt

Invoices factored by third parties are typically paid within a few days or 24 hours by third-party factors. In particular, smaller companies can benefit from timely cash flow by feeling more confident about covering near-term expenses.

• Removal of a likely distraction

A slow-paying customer and one with overdue bills can cause many headaches for a small business, especially in the case of late payments. 

A late invoice may require the owner to spend additional time focusing on other customers or higher-value activities instead of dealing with the late invoice. 

Trying to collect the payment of outstanding invoices can harm the morale of an accounts receivable department if they are responsible for collections.

• Approvals are faster than with bank loans

To maintain the cash flow, bank loans and lines of credit are reasonable options. It can take time for small businesses to get them; for many, their levels may limit their ability to grow. A factoring company allows you to receive cash faster than a bank because of how the arrangement works.

• The credit history of a founder is less scrutinized

The founder’s credit score often determines the availability of bank loans. Small-business owners often face this dilemma, mainly if they use their credit cards heavily for funding. 

Invoice factoring is more interested in the credit rating of the company whose invoices it purchases than in the credit rating of the company that has placed the order.

• Helping businesses work with critical new customers and accounts

Small businesses may find it challenging to meet the payment schedules of some vast and otherwise reliable clients. 

Payment timing issues could complicate an order from a government agency or Fortune 500 company that could significantly impact their fortunes. These new orders may be fulfilled through invoice factoring work.

Pitfalls

It is also essential for businesses to consider the downsides of factoring before selling invoices to a third party. There are several disadvantages to this method:

• It requires a lot of commitment

“Spot factoring,” which refers to factoring a single invoice, is sometimes offered by factoring companies. It is far more common for factoring companies to work only with companies that are willing to make the majority of their invoices available for factoring. It is common to establish a contractual minimum, and if invoices don’t meet it, a fee is charged.

• There can be a cost associated with it

Unlike bank loans, invoice factoring costs are based partly on perceived risk, but credit ratings are made by customers, not a company’s owner. 

As a general rule, invoice factoring costs are generally several percentage points higher than the interest a business would pay on a bank loan, even when we are concerned that the risk of nonpayment is low.

• Doesn’t shift the payment risk

An earlier cash receipt can benefit a company, but it doesn’t guarantee protection against nonpayment by customers. Factors usually advance cash to the selling company if an invoice fails to pay unless a “non-recourse” clause exists. It increases the cost of the arrangement, however, by including this clause.

• This makes it harder to control certain interactions with customers and their impressions

Factoring arrangements usually ensure that invoices are paid. Worrying about this is a benefit of factoring for companies selling invoices. As a result, the company becomes less able to handle collection requests. 

The perception of a company it purchased from could be negatively affected by an aggressive factor focused on its own short-term needs. 

As a result of the presence of a factor, customers may believe that the company lacks the necessary resources to conduct business.

It is possible to manage these downsides. The factor can represent itself as part of the company’s financing department, for instance, via confidential factoring. 

Invoice Factoring Working Process

There are several ways in which invoice factoring work, but you should invoice your customer immediately after they have paid for the goods or services. 

Once you have decided which factoring company is right for you, you can contact them, go through the application process (if you haven’t already done so), and sell them your unpaid invoices. 

A factoring company will sign an agreement with you once the screening process has been completed and set an initial amount you can borrow from them as a loan advance when you have passed the screening process.

The factoring firm usually pays you the advance within 1-4 business days, usually between 75-90% of the invoice amount. It is determined by risk factors, the industry in which you operate, and the value of the transaction. Invoice factoring begins once the invoice financing company pays your advance.

The factoring firm will deduct the factoring fee from your invoice amount, and then you will receive the balance. 

Alternatively known as a discount rate, the factoring fee is what it costs to borrow money from an invoice financing company. 

It will be higher if the customer takes a long time to pay the invoice. It is usually charged weekly or monthly. Depending on the industry, discount rates range from 1% to 5%.

How Much Amount to Spend on Invoice Factoring?

There are two essential parts to invoice factoring fees: 

The discount fee + the service fee 

Generally, invoice factoring costs have average base rates for both. Because fees typically depend on various factors, this range is not very informative.

Let’s take a closer look at these two main fee components.

Discount fee 

Factoring companies charge a discount fee (also called a discount rate or factor rate) when they factor an invoice.

There is usually a 1.5 – 5% range based on the invoice value. Discount rates apply only to advances, and the rate is generally calculated annually before being charged weekly or monthly.  

You would pay $410.95 if it were 5% of a single $100,000 invoice with a 30-day term and used invoice factoring ((5,000 ÷ 365) x 30). 

Invoice factoring companies provide advances at interest rates.

Service fee 

Invoice factoring companies charge service fees for various services related to managing and processing invoices.

Usually, it ranges from 0.5 to 2.5% of the invoice value. In the same way as the discount charge, its precise figure depends on multiple factors.

Five Steps to Invoice Factoring

When business owners need money now to pay invoices due by customers later, invoice factoring may be the solution. It may, at first, appear daunting to apply for a mortgage or file your tax return instead of filling out an application for a mortgage or filing your tax return.

Filling out paperwork and sending detailed documentation is certainly a commitment, and a lot is involved in completing an application that requires documents to be submitted. 

It’s essential to consider the complete invoice factoring cycle if you want to make an informed decision about whether an invoice factoring service is truly the best option for your business after researching invoice factoring as an option.

It’s easy, but you’ve got to be prepared.

1. Initial contact 

During the initial contact, we will establish whether you are a good candidate for accounts receivable funding.

2. Provide needed documentation for the application form

The next steps are to provide the requested documentation and fill out an application form. Throughout the process, your current and aging accounts receivables are the most critical documentation. 

You must verify your clients’ creditworthiness with your factoring company before they can pay your invoices on time. Your factor will give you a better rate if you have an excellent payment history. 

Your customers must show a prompt payment history rather than your credit score. If you do not have perfect credit, don’t let that deter you from applying. A traditional invoice factoring process can only consider invoices for already delivered goods or services. 

There will be a need for the factor to verify receipt of the goods or services. Regarding factoring, extended payment terms of more than 90 days may also pose a problem.

3. Documents to verify company legitimacy 

Your factor will require documents verifying the legitimacy of your company. They must confirm your registration with the appropriate government agencies to prevent fraud from occurring. There may be issues with late tax payments, outdated books, or liens attached to accounts receivable that prevent you from qualifying.

4. AR Financing company will interact

Once all the documents are produced and risks are considered, an underwriting team member from your accounts receivable financing company will contact you. 

Invoice factoring companies usually offer 70 – 90% of invoice value depending on the risk they believe they are taking by advancing money. 

The amount of risk will also determine your rate. During this process, you can seek advice and support from a company specializing in invoice factoring.

5. A commitment

Once your customer has signed a contract and the factor has accepted the invoice, they will advance you the stated percentage, with the remaining payment going to you once your customer has paid according to their terms. 

Your customers will pay the factor. 

Many factors can make you nervous about a third party handling your payment. 

Still, you should thoroughly discuss the process with the third party to make sure that you are assured that the collection process will be handled professionally.

After your factoring agreement is in place and your customers continue to pay promptly, the process can be repeated repeatedly, maximizing your cash flow and growing your business.

To make the invoicing process easier for your outstanding invoices, consider turning to InvoiceoOwl. 

Invoice Factoring vs. Other Lending Businesses

Even though many small business loans are available and alternative financing options, many of them might not be the best option for all businesses. 

Depending on the lender, a credit score or an operating history may be required to qualify. 

As for others, some of them can be fast and easy, but they can also be expensive and predatory. 

Your goal is to find a type of small business lending that provides a solution to your needs at a cost that is reasonable and manageable for you.

Invoice factoring vs. accounts receivable financing

Factoring invoices and financing accounts receivables differ primarily in the underwriting criteria. There is more flexibility with factoring but stricter credit requirements with A/R financing. Therefore, funding A/R is typically more favorable than other types of funding.

Factoring invoices and financing accounts receivables benefit businesses by providing them with funds before collection. Both financing options put money into your business quickly, which means they are a good choice when working capital is a critical component of your business operations. 

Both offer receivables management and credit services, and factoring and A/R financing are both provided by many providers.

Invoice factoring vs. invoice financing

Regarding invoice factoring versus invoice financing, the main difference is who collects the funds after the invoice is issued. When you finance invoices, you keep control of the collection process. 

On the other hand, factory companies are responsible for collecting the purchased invoices. In most respects, both forms of financing are nearly identical, except for the collection process (i.e., assignment).

Invoice factoring vs. invoice discounting

Factoring and discounting invoices are often mistaken for the same thing. Despite their similarities, they differ in some crucial ways. As a general rule, factoring and invoice discounting are transparent processes.

Conclusion

There are many reasons why a factoring company is an excellent choice for small business owners. One reason is that factoring companies take over your collection responsibilities, meaning you have more time to focus on your business. 

In case you are experiencing a problem with collections, you not only have customers who don’t pay on time but also cannot deal with it on your own. Here factoring company may be an option since it puts that responsibility on a third party with experience in collection work.