Comprehensive Guide to Invoice Factoring

Running your entrepreneurship is not an easy task, even when you do everything right. Especially, this gets difficult when you have to wait for clients to pay necessary invoices while your bills and payroll need immediate attention.

Sounds familiar, doesn’t it?

As a small business owner, having a gap in the cash flow soon turns into a nightmare. Failing to address it can disrupt basic operational activities such as salaries, utilities, and inventory.

This is where you say hello to invoice factoring.

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

Understanding Invoice Factoring

Before understanding how invoice factoring works, let’s learn about what invoice factoring is.

Key definition

The invoice factoring process is when a business owner sells invoices to an invoice factoring company in exchange for an advance of cash. On average, the invoices are payable in 60-90 days. This means that you can expect to not receive the payment for your services for at least a month after the invoice is sent to your client (if not longer).

Does that mean your business can stop operations? No. At this point, businesses turn to invoice factoring as a way to address these challenges and keep operational processes smooth.

Real-world examples

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. 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. She decided to approach an invoice factoring company.

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 a free trial and access its premium features that give you more than just generating invoices.

Now let’s check out some of the benefits of invoicing factoring.

The Benefits of Invoice Factoring

Invoice factoring can be advantageous for small companies. How?

You’re about to find out.

Key advantages

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

Quick access to cash

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.

Focus on core business

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.

Faster approvals compared to 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.

Minimal credit history requirements

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.

Facilitation of new business relationships

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.

Common Pitfalls in Invoice Factoring

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:

1. Considerable commitment needed

“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.

2. Associated costs

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.

3. Risk-retention

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.

4. Impact on customer relations

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. 

How Invoice Factoring Works

After researching invoice factoring as an option, it’s essential to consider the complete invoice factoring cycle to make an informed decision about whether an invoice factoring service is truly the best option for your business.

There are several ways in which invoice factoring works, but you should invoice your customers immediately after they have paid for the goods or services. Below are the following processes:

Step-by-step process of invoice factoring

Check out the invoice factoring process in detail:

1. Initial inquiry

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

2. Documentation submission

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. Verification procedures 

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. Factoring company engagement

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. Final commitment and funding

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.

Costs Associated with Invoice Factoring

While invoice factoring is a great way to maintain a steady cash flow, it comes with its own set of additional costs. These include:

Discount fees

Discount fees include the percentage deducted from the invoice value by the factoring company. On average, these fees would include 1% to 5% of the overall amount. It ultimately depends on factors such as the client’s creditworthiness, invoice size, and industry. The fee structure is tiered and increases with each day that the invoice remains unpaid.

Service charges

Service charges are additional fees charged by invoice factoring companies. They are charged to cover operational expenses such as invoice processing, credit checks, and payment collections. These charges are either fixed or based on a percentage of the invoice value, typically ranging from 0.5% to 3%.

Invoice Factoring Compared to Other Financing Options

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.

Versus 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.

Versus 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).

Versus 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.

Core differences explained

Factors	Invoice factoring	Accounts receivable financing	Invoice financing	Invoice discounting
Ownership of invoices	Factoring company collects payment	Business has the ownership of invoices	Business has the ownership of invoices	Business has the ownership of invoices
Collection responsibility	Manages customer payment collection	Business handles collections	Business handles collections	Business handles collections
Funding basis	Advance on the total invoice value	Loan or credit line secured by receivables	Advance against specific invoices	Discounted value provided for invoices upfront
Fee structure	Discount fees and service charges	Takes interest on the loan amount	Interest and fees on the financed amount	Discount fee deducted from invoice value

Identifying the Need for Invoice Factoring

Regardless of the size of your business, you need to understand the situations where factoring fits can help you stabilize finances and fuel growth.

Let’s understand the factors that help you know the need for invoice factoring:

Target audience and use cases

Invoice factoring is ideal for businesses with consistent receivables but delayed payments. If you are a small business that lacks the credit history to secure loans, you can opt for invoice factoring instead.

You can also go for it if you’re a seasonal business like retail or construction that needs cash to cover operational expenses in peak periods. There are certain use cases where invoice factoring is popular, such as funding payroll, purchasing inventory, or maintaining cash flow in a specific time frame.

Invoice factoring vs. loans: Which is better?

While loans provide a lump sum repayable over time with interest, invoice factoring offers immediate cash ties to receivables. So, unlike loans, factoring doesn’t create long-term debt, making it appealing for businesses to avoid financial liabilities.

However, you should opt for loans if you have a long-term project that requires substantial capital. It is perfect if you need predictable repayment terms and larger amounts for expansion. The choice usually depends on the urgency of cash flow and financial strategy.

Conclusion and Next Steps

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.