What is invoice factoring and how does it work?
Invoice factoring is just another option in the arsenal of working capital levers businesses have at their disposal. Here’s everything you need to know about what it is, and how it works.
Modern businesses can use a variety of financial instruments, tools, and techniques to optimize their cash flow, improve their working capital position and realize their business plans. These include programs that can be initiated by the buyer, as well as those that can be initiated by the supplier.
Buyers, for example, can use different methods to support their suppliers by offering early payment for their invoices. Dynamic discounting allows suppliers to take early payment in return for a discount – meaning that buyers can put their surplus cash to work and earn a risk-free return. Alternatively, buyers can use supply chain finance, which uses third-party funding to pay suppliers early – the buyer then pays the funder in line with the agreed payment terms.
Suppliers can take advantage of such programs when they are provided by their buyers. In other instances, they may adopt other methods to secure early payment on their invoices. Invoice factoring is one such approach.
Let’s look in more detail at how invoice factoring works.
What is invoice factoring?
Invoice factoring is a form of receivables financing that invoices selling some or all your outstanding invoices to a third party – the factor – who pays you a percentage of the value of the invoice. The factor then collects payment from your customers when the invoice is due, and pays you the remainder of the invoice value, minus a fee.
Companies can therefore use invoice factoring to speed up their cash flow and unlock working capital. Invoice factoring is also sometimes known as accounts receivable factoring, debt factoring, or invoice financing.
How does invoice factoring work?
The invoice factoring process can vary between different financing providers, but generally it will include the following steps:
- The business provides goods or services to a buyer.
- Accounts receivable creates and raises the invoices for the goods or services.
- The business sells the unpaid invoices to a factoring company and receives a percentage of the value of the invoice (typically 70-90 percent).
- The factoring company collects payment from the original customer.
- Once the customer has paid, the factor pays the business the remaining balance of the invoice, minus a factoring fee.
Invoice factoring may be provided either with recourse or without recourse. With recourse factoring, the company remains liable if customers fail to pay their invoices, meaning that cash would need to be returned to the factor. In the case of factoring without recourse, the factor accepts all liability for invoices that are not paid. As such, the fees tend to be higher for non-recourse arrangements.
Invoice factoring example
By way of an example, suppose that Company ABC has carried out work for a customer and is ready to invoice, However, ABC needs cash quickly to fund the purchase of new equipment – so ABC decides to put in place a factoring facility with Factor XYZ. When ABC raises an invoice for $15,000, XYZ advances the company 80% of the value of the invoice, i.e., $12,000. XYZ then chases in payment from the original customer, after which it sends the remaining invoice value to ABC with the factoring fee deducted.
Benefits of invoice factoring
Invoice factoring can provide several benefits for companies. These include:
- Improved cash flow and working capital. When companies sell invoices to a factor, their cash flow becomes more controlled and predictable, meaning they can access cash quickly, plan more effectively, and make better use of their working capital.
- Alternative form of finance. Factoring represents a flexible alternative to other sources of finance, such as bank loans – this can be particularly appealing to companies that may struggle to access traditional lending, or businesses that need access to finance quickly.
- Remove responsibility for chasing payment. The factor takes on the responsibility for chasing payment of outstanding invoices. This enables the company to outsource a time-consuming task and free up resources for other activities.
When to use invoice factoring
There are many reasons why a business might want to take advantage of invoice factoring. This approach may be suitable if you:
- have many high-value outstanding invoices, and lack the resources needed to chase in overdue payments
- need to boost your cash flow
- are looking to avoid long-term debt
- need access to working capital to repay a business loan or pursue growth opportunities
- are looking to take advantage of short-term or seasonal opportunities.
Invoice factoring vs invoice discounting
Invoice factoring is just one of several forms of accounts receivable financing available to businesses. Another closely related option is invoice discounting, in which the company’s unpaid accounts receivable are used as collateral for a loan.
In an invoice discounting arrangement, the invoice discounting company advances a percentage of the invoice amount as a loan. The company remains responsible for collecting payment from the customer. Once the customer has paid, the company pays back the invoice discounting company, plus interest.
Invoice factoring and invoice discounting have some similarities, as they both give companies the opportunity to access funds quickly based on their accounts receivable. However, the two techniques differ in several important ways:
- Collecting payment. With invoice factoring, the factor deals with your customers. In contrast, with an invoice discounting arrangement, you remain responsible for collecting payments, with customers paying you in the usual way. Outsourcing collection activities can reduce your administrative burden, but it is important to ensure that customer relationships are not adversely affected. Some businesses may prefer to continue to pay their invoices first hand to avoid any supplier relationship risks.
- Confidentiality. Your customers will be aware that you are using invoice factoring, whereas invoice discounting is confidential. This may be a consideration if you are concerned about negative perceptions of your business.
- Sale of invoices. An invoice factoring arrangement involves selling the rights to the invoice to the factoring company. This is not the case with invoice discounting, in which the invoice is used as collateral for a loan.
- Value-adding services. Invoice factoring companies can provide value-adding services alongside the factoring arrangement, such as full sales ledger and collections services. This does not tend to be the case with invoice discounting arrangements.