8 min read
25 May 2022
8 min read
25 May 2022
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.
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.
The invoice factoring process can vary between different financing providers, but generally it will include the following steps:
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.
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.
Invoice factoring can provide several benefits for companies. These include:
There are many reasons why a business might want to take advantage of invoice factoring. This approach may be suitable if you:
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:
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