What is Invoice Factoring and How Does it Work?

One of the biggest frustrations that business entities face is waiting to get paid. Firms that have lumpy cash-flow, seasonal business or long payment cycles can especially relate. Some clients are slow payers or demand generous terms. It does not have stop operations because it is possible to transform invoices into working capital to continue running your company, hire new employees or carry out expansions.

Invoice factoring is a type of debt finance financial transaction where a company sells its receivable accounts or invoices to a third party which is known as the factoring company. The business does this at a discount in a bid to meet its immediate and present cash needs.

It implies that instead of an organization waiting for 30 or 90 days for their clients to pay any outstanding invoices, they get an advance on the invoice within a day or two from the factoring company. Invoice factors have three parts i.e.

The advance

It is the lump sum that the business gets in one day or two for instant use. The total amount varies depending on the industry and the invoice’s amount. Mostly, they are usually about 70% to 90% of the total of the invoice.

Discount Fee

It is the money that the lender charges for agreeing to take on the debt’s risk. In most cases, this covers around 1.5% to 6% of the due amount.

Reserve

It refers to the invoice’s remaining percentage. Factoring firm deducts the discount fees, and the amount is paid to the company as soon as customers pay the invoice.

Steps Involved in Invoice Factoring

  1. You invoice clients- after receiving services or products, companies issue invoices for payment.
  2. Assign/sell the invoice to a factor- look for an ideal Factor and go through an application process to sell them the outstanding invoices. Factoring firms usually conduct due diligence to see if they will take up the risk.
  3. Factor pays an advance- the company will give you an advance rate. It also notifies customers about the agreement.
  4. Customers pay the Factor within stipulated time frames
  5. Factor gives you remaining balance- after deducting their fees, the company forwards the remaining balance.

Who Qualifies for Invoice Factoring?

Many businesses find that it is easier to qualify for factoring because they do not focus too much on profitability, annual revenues, and credit scores. Factors that affect qualification mostly include:

  • Clients must have established entities with reasonable credit scores. Companies should also invoice business (B2B) or government (B2G) clients.
  • The invoices should be payable or be due within ninety days and are not subject to any other loans whether short-term or long-term.
  • The business should not have a history of legal or serious tax issues.

Perks of Factoring

There are numerous perks companies enjoy with selling their invoices like:

  • Faster access to funds rather than waiting for months for their customers to pay invoices. It is a valuable tool that companies can use to fill short-term cash flow gaps.
  • It is possible that a company may end up receiving a bigger percentage of the invoice within two days. Keep in mind that it depends on the industry.
  • The process benefits establishments that are still in the process of gaining momentum or are still facing some financial challenges and are not able to access traditional financing.
  • It gives establishments growth opportunities without having to incur debt or dilute equity.
  • The process helps business individuals to save time because they do not have to keep chasing payments.

Cons of Invoice Factoring

  • Depending on whether a company has picked non-recourse or recourse factoring, it may have to pay back all the advanced amount if their clients do not end up honoring their payments. With the non-recourse options, business ends up paying higher fees because of increased risks.
  • Discount percentages are subject to increases especially if the invoice is not due for extended periods. When customers delay making payments, it can also decrease the amount that the organization ends up receiving.
  • Not all firms qualify- factoring companies review sales volumes and creditworthiness of a company before they go ahead and purchase their invoices. At times, the bad credit of the clients may make the factoring firms to refuse to make the purchases; thus, denying the company the funds that it direly needs.
  • Can ruin business reputation- clients may be aware that the establishment is turning over its debts to third parties once they start receiving statements. It is a move that could hurt the reputation of the firm particularly in the case where the factoring company does not extend similar client service experience to its customers.

Worth noting is that invoice factoring is most suitable for small businesses as it is usually not used for significant capital investments.

Guide for Choosing the Ideal Factoring Firm

Since many companies offer the service, it is essential that a business is diligent when choosing the one to work with. Some of the things to look out for include:

Transparency in Fees and Rates

Run away from firms that do not make their all-inclusive fees as transparent as possible. Avoid hidden costs especially from service providers who advertise suspiciously low factoring fees and end up covering them up with other unscrupulous means.

Stay Away from Contract Traps

Long-term contracts are one of the ways that factoring companies use to protect their profits. It is a good move on their end, but not beneficial for your entity. Where possible, never sign one. However, if it is mandatory, be sure to keenly read through to ensure that you protect your interests as well.

Understand Penalties and avoid them

Many companies usually have penalties that are not well-known. Seek to find out what triggers such, and evade them. Never work with a firm that has foul penalties. Remember always to do thorough research so that you end up working with a fantastic company without unlimited consequences and costs.


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