Invoice factoring: how it works & when to use it
straight to your inbox
Imagine this: your small business just landed a major customer that could take you to a whole new level, but only if you wow them with your products and some stellar customer service.
But here’s the catch: this new business win is going to mean a lot of upfront work and a whole range of unplanned-for-expenses. For example, you might have to:
- Hire new colleagues who know their way around similar customers
- Pay a supplier upfront to get an important project moving sooner
- Upgrade your software subscriptions to help you serve the big account efficiently
You could ask your bank for a loan but you know they’ll want to see proof your business is actually doing well with cash flow right now. And for some businesses with specific operating models, this simply isn’t a realistic option. It’s in situations like these that founders and their teams may begin to seriously consider invoice factoring.
So let’s take a close look at this business financing method.
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 in advance of cash flow concerns, so that 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 have an impact on 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 bears the final responsibility for invoice payment; the factoring company purchases the invoice with the knowledge that 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. 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, due to their risk.
Invoice factoring vs. invoice financing: what’s the difference?
Invoice financing (also called 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.
Which types of companies are invoice factoring a good fit for?
Many smaller, growth, or high-risk companies that cannot access the banking market can get access to vital working capital with invoice factoring. Some other business situations that invoice factoring may be a good solution for include:
- Companies that can't wait on cash flow: If you need access to cash flow fast or if you don’t want to deal with the traditional local bank credit line process, then maybe invoice factoring is an option for your business.
- Companies with strong accounts receivable: There is more day-to-day work involved in factoring than borrowing, as you have to provide the invoice, and in some instances, further accounts receivable (AR) information for every invoice.
If you don’t mind waiting on funds, or if you don't have the time and resources to manage follow-up AR queries, it may be worth looking into other banking or financing options.
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.
Pro: 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.
Pro: 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.
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.
Con: 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.
Con: 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.
Con: 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:
- Administrative fees
- Processing fees
- Funding fees
- Termination fees
This can end up being more expensive than waiting for your customer to pay you, depending on how long your Days Sales Outstanding (DSO) is.
Con: Customer non-payment
And perhaps one of the biggest drawbacks with invoice factoring is this: 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 take that example we mentioned at the top and apply it here. But let’s call the imaginary company Rocket Customer Growth (RCG).
- RCG won a major enterprise customer, which is causing cash flow issues, because they’re creating upfront expenses during onboarding and initial account servicing
- But that doesn’t change the fact that RCG customers still take anywhere between 30 and 90 days to pay their invoices
- Instead of seeking a bank loan or using a business credit card for these expenses, RCG applies to QZX Factoring
QZX advances RCG 75 percent of the total amount of RCG’s outstanding receivables. Just under three months later, when all these invoices have finally been collected, QZX pays RCG the remaining 25 percent, after taking its factoring fee.
Who might be a good fit for invoice factoring?
As that basic example shows, any business that has outstanding receivables can be a good candidate for invoice factoring.
- Generally, you must have a solid credit history and track record of repaying your creditors on time
- Your business must be current with all of its invoices and be able to provide an aged receivables report that proves this is the case
- Other factors that may be taken into consideration include your average monthly revenues, your profit margin, your payroll costs, and the volume of invoices that are typically paid by customers in your industry.
How to choose an invoice factoring lender
Choosing the right invoice factoring lender can be difficult, but with an understanding of your business’s needs and a few key questions, you can find the right fit.
Negotiating the right terms with invoice factoring lenders requires a bit of preparation. You'll want to be sure you’re getting the best deal before committing to a factoring company or bank.
After all, your business depends on getting paid promptly and properly. When talking to potential lenders, these are some important questions that you should ask.
- 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.
The alternatives to invoice factoring
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.
Using Ramp to make sound financing choices
While Ramp doesn’t provide invoice factoring, our commerce sales-based underwriting gives businesses access to credit limits up to 30x higher than traditional corporate cards. Plus we offer 1.5% cashback on all purchases instead of non-monetary rewards like airline miles. Our finance automation software also gives you spending and merchant controls, expense policies, and approval chains to manage business spend.
Ramp’s finance automation tools can help businesses avoid relying on invoice factoring too soon, by categorizing each line item on your invoice to help you close your books up to eight days faster.
For businesses that do need factoring, our solution can sync with your accounting software to prepare your aged receivables—and then help you manage the cash flow you've just secured in the most optimal way.
Since credit and credit history are not used, you can qualify for invoice factoring with bad credit, which makes it different from a traditional bank loan or small business loan. Companies use their outstanding invoices from customers as proof of ability to pay back the loan.
Finding and choosing an invoice factoring service are two different things. Finding one is as simple as a Google search, but choosing one that fits your needs with reputable reviews is a different story. You can also choose an alternative to invoice factoring like Ramp’s sales-based underwriting to get the quick capital you need.