Invoice factoring 101: How it works
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Invoice factoring can be a game-changer for businesses seeking quick access to cash without taking on debt. Businesses can unlock funds to cover expenses or fuel growth by selling unpaid invoices to a factoring company. This guide walks you through how invoice factoring works, its types, costs, and how to determine if it’s the right fit for your business.
We'll also explore the pros and cons, alternative financing options, and tips for choosing the right lender. If you're looking for ways to enhance your cash flow management, keep reading to learn more about this powerful financial tool.
What is invoice factoring?
Invoice factoring is a means for a company to borrow money based on the value of their outstanding invoices from customers. This means that the cash flow from unpaid invoices can be used to meet the company's ongoing expenses and fund its growth without incurring debt. Businesses usually arrange invoice factoring before cash flow concerns so the company has funds available when needed.
How does the invoice factoring process usually work?
In most cases, invoice factoring firms make two payments. The first is created instantly upon the sale of the invoice, and the second is created upon the client's payment of the invoice. From a financial management perspective, invoice factoring will also impact some of your key accounting processes.
- Third-party companies typically take complete responsibility for collecting payment from customers when an invoice is sold.
- The factoring company receives a portion of the entire invoice amount that was originally charged to the business’s client.
- Before the customer pays for the goods or services, this transaction allows firms to obtain immediate access to cash so that they can immediately reinvest that money.
What are the different types of invoice factoring?
There are two main kinds of invoice factoring: recourse or non-recourse invoice factoring. They might sound like complicated terms, but all they really designate is who is responsible for collecting payment for the invoices that you've chosen to factor.
- Recourse factoring: Here, the seller is responsible for invoice payment; the factoring company purchases the invoice knowing it will be paid. If a buyer fails to pay within a certain term, the factoring company has the authority to seek full payment of the invoice amount plus the factoring service charge from the seller.
- Non-recourse factoring: Alternatively, this type of factoring means that the seller is not ultimately liable for the payment of the invoices factored. Due to their risk, these agreements are usually more expensive and may have additional payment terms, such as reduced credit limits or eligibility for only a portion of the ledger.
What does invoice factoring cost?
The cost of invoice factoring varies depending on several factors, including the creditworthiness of the business’s customers, the volume of invoices, and the industry. Typically, invoice factoring fees range from 1% to 5% of the invoice value. Additional costs can include administrative fees, processing fees, and penalties for unpaid invoices. If invoices remain unpaid for a longer period, factoring companies may charge higher rates. It’s essential for businesses to carefully review the terms of their factoring agreement to understand the full scope of the fees and potential expenses involved.
How to use invoice factoring in your business
Invoice factoring can be a valuable financial tool for businesses needing quick access to working capital, especially when traditional banking options aren’t feasible. Here’s how you can determine whether invoice factoring is right for your business and its potential benefits.
Understanding If you’re a good fit for invoice factoring
Invoice factoring is particularly useful for companies that have strong accounts receivable but face cash flow challenges due to delayed customer payments. Businesses that might be a good fit include:
- Companies that can't wait on cash flow: If waiting for customer payments is hindering your business operations, or if going through a lengthy credit line process with a bank isn't an option, invoice factoring can offer faster access to cash.
- Businesses with reliable accounts receivable: Invoice factoring requires you to submit invoices and provide accounts receivable information to the factoring company. If your business has a solid track record of on-time payments from clients and accurate accounts receivable records, factoring could be an ideal solution.
- Businesses with limited access to traditional financing: If your company is smaller, rapidly growing, or considered high-risk by banks, invoice factoring provides a way to unlock capital that might not otherwise be available.
However, if you’re able to manage cash flow without much disruption, or if handling day-to-day AR queries is too time-consuming, traditional financing options might be a better fit.
Understanding the benefits
Using invoice factoring can help businesses in various ways:
- Improved cash flow: Invoice factoring gives you access to funds quickly, often within days, helping you cover immediate expenses like payroll, inventory, or operational costs without waiting for customer payments.
- Avoiding debt: Unlike traditional loans or credit lines, invoice factoring doesn’t add debt to your balance sheet. You’re simply receiving an advance on money you’re already owed.
- Flexible financing: Factoring adapts to your business's sales cycle. As your sales grow and invoicing increases, the capital available through factoring also grows, offering more flexibility than traditional loans.
What are the pros & cons of invoice factoring?
Before we look at other financing methods, here are the pros and cons that startup founders may want to consider.
Pros
- Rapid access to cash flow: The main advantage of invoice factoring is cash, when you need it. Factoring allows businesses to get paid for their products and services in days, rather than waiting between 30 and 90 days for payment. This can be a huge help for businesses that are struggling to make ends meet or that need to make large purchases. Invoice factoring can also help businesses build their credit scores, as payments made on time will be reported to the credit bureaus.
- Low barrier to approval: Where your local bank’s line of credit can take three months or more to secure, you can get through the invoice factoring application process faster. Depending on the lender, you may receive funds in as little as 24 hours. With many factoring companies, there are also no long-term contracts or upfront costs. Your business only pays for what you use.
- Collateral-free: Unlike other forms of financing, invoice factoring does not require collateral and approval is based on the creditworthiness of the customer, not the business. This makes it an ideal solution for businesses with poor credit or limited assets.
Cons
- Outsourced collections: Outsourcing something as sensitive as invoicing and payment collection might be difficult. The factoring company will be in charge of all communications during the invoicing and collection process. As a result, existing clients of a company may receive more demanding messages than they are accustomed to. Customer relationships may suffer in the long run if the emphasis moves to bringing in cash for the period of the ledger from sustaining strong customer service.
- Impact on accounting: You may need to ask your accounting team to revisit some accounts receivable processes (and it may make sense to partly automate invoice processing during this period). Other potential impacts include factoring providers asking you to lower your customer credit limits or amend your payment time frames on certain accounts.
- Higher fees: Some factoring companies will charge between one and five percent in additional fees per week for the ability to access your funds early. Some factoring companies will also charge admin fees for processing, funding, and termination.
- Customer non-payment: Perhaps one of the biggest drawbacks with invoice factoring is that there is still no assurance that your customers will pay the invoices to the factoring company. When this happens, the factoring company might demand your business ‘buy back’ the invoices or that you replace them with invoices with higher outstanding balances.
An example of the invoice factoring process
Let's look at a real-life scenario to understand invoice factoring. Consider the fictional company, Rocket Customer Growth (RCG). RCG recently landed a major enterprise client, which led to upfront expenses during onboarding and account servicing. However, their clients still take between 30 and 90 days to pay invoices, causing cash flow challenges.
Instead of turning to a bank loan or business credit card, RCG applies to QZX Factoring. QZX advances 75% of RCG’s outstanding receivables upfront. Nearly three months later, when the invoices are fully paid, QZX transfers the remaining 25%, minus their factoring fee.
How to choose an invoice factoring lender
Choosing the right invoice factoring lender requires careful consideration and preparation. To ensure you're getting the best deal and a reliable partner, it's crucial to understand your business’s specific needs and ask key questions during the selection process.
- Ask to be assigned a single point of contact who will answer all of your questions and be sure to ask about their customer support options and availability
- Ask for their fee structure. Factor rates vary, so make sure you know what the fee is on each invoice (it’s usually between three and five percent)
- Ask what the turnaround time on payments is
- Ask how quickly they can provide funding and whether their payments are made daily or weekly. Ideally, you need a company that will pay within three days of receiving your invoices.
- Ask how long have they been in business as well as whether they have worked with your industry in the past. Look for companies that have been in business for at least five years, preferably more.
You may also want to consider checking their online reviews, whether they have any reputable customer case studies on their website, and their Better Business Bureau rating.
Invoice factoring alternatives
Understandably, some startup founders may have reservations about giving their aged receivables to a third party or paying the invoice factoring rates some providers require. Other founders may feel like they have little choice when they're faced with significant expenses. But there are other choices. Invoice factoring is only one of several ways to get cash flow support for your startup.
Other options include:
- Standard bank loans: With a business bank loan, you can borrow a set amount over a set period of time, covering anywhere from a few months to several years. Your business will need to prove you can repay the principal amount you borrowed, plus any interest, and it may take weeks or even months to get an application over the line.
- Working capital loans: These loans are designed to help businesses with daily operations and expenses. They can be used for a variety of purposes, including inventory, payroll, and marketing. Similarly, cash flow loans can be used to cover unexpected expenses or bridge a gap between payroll periods.
- Business line of credit (LOC): You can use LOCs for temporary cashflow problems or emergencies. Think of a business line of credit as an overdraft, with bells on. You’ll need a bank or lender to approve your application.
- Business credit card: Business credit cards can also get your business out of a jam, because they allow you to pay for all kinds of expenses. But long-term, credit card loyalty and reward programs are unlikely to make up for their high-interest rates and unfavorable repayment terms.
These additional options won’t suit every business. And that’s especially true for small business owners who want to avoid choosing between sacrificing accounts receivables control for quick cash flow, or slow and frustrating business credit applications.
Invoice factoring vs. invoice financing: what’s the difference?
Invoice financing (slightly similar to invoice discounting) and invoice factoring are often confused. While they are not the same, they are similar. With both invoice factoring and invoice financing, you won't have to go through a credit check because it's more important how likely your customers are to pay. This means:
- You won't have to put up collateral because the invoices are the collateral
- You will receive the cash or loan fast, usually within a couple of days
- You don’t have to wait for customer payments to use that cash in the business
However, with invoice financing companies will lend you money based on your outstanding receivables. They'll charge you a monthly service fee and an interest rate for the amount you borrow. Unlike invoice factoring, you retain control over the collection of the invoice.
FAQs about invoice factoring
Is invoice factoring complicated?
Invoice factoring may seem complex, but it's relatively simple once understood. It involves selling unpaid invoices to a factoring company for immediate cash, while they handle customer collections. The process has two main types—recourse and non-recourse—which determine liability if customers don’t pay.
While fees vary (typically 1-5% of the invoice), it's crucial to understand additional costs like administrative or processing fees. The main challenge lies in balancing potential impacts on customer relationships, as a third party handles payments. With proper understanding, invoice factoring can be a useful and straightforward financing option.
How long does it take to get approved for invoice factoring?
Approval for invoice factoring is typically faster than traditional bank loans. Most factoring companies can approve businesses within a few days, sometimes in as little as 24 to 48 hours. The exact timeline depends on factors like the company's application process, how quickly you can provide required documentation (e.g., invoices, financial records), and the creditworthiness of your customers. Once approved, funding can be released just as quickly, often within 24 hours of submitting an invoice.
Are invoice factoring contracts renegotiable?
Yes, invoice factoring contracts can often be renegotiated. Many factoring companies offer flexible terms, especially if your business relationship is long-standing or if your sales volume increases. You can renegotiate aspects such as fees, advance rates, or contract length. It’s important to regularly review your agreement, as changing business conditions or improved cash flow might provide opportunities to negotiate better terms. However, some contracts may include fixed terms or fees that could be more challenging to adjust, so it's important to carefully examine the original contract for any restrictions.
Invoice factoring isn’t your only option—try Ramp Flex
Ramp doesn’t offer invoice factoring, but Ramp Flex, part of Ramp Bill Pay, lets you pay vendors now and repay Ramp in 30, 60, or 90 days—no factoring needed:
And you’re on your way—flex your bills on your own terms.
*Ramp Flex is subject to credit approval and restrictions, and will not be available in all states. Loans issued by Ramp Financing Corporation and/or Lead Bank. Visit ramp.com/flex for more info.