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What is Invoice Factoring and How Does it Work?

Organizations with slow-to-pay accounts receivable often rely on invoice factoring as a way to increase cash flow. It is also a popular solution for newer companies or those experiencing rapid growth. The factoring company buys your invoices, makes an immediate payment (typically a percentage of the invoice total), and pays the remaining amount upon payment of the invoice, minus a small fee.

What is Invoice Factoring?

Not just any business can use invoice factoring. Typically, the option is only available to businesses that invoice other businesses or government agencies. It is particularly popular with healthcare providers and construction companies, where accounts receivable often exceeds 30 days. Some people use the terms invoice factoring and invoice financing interchangeably. This is incorrect. Invoice financing involves obtaining credit based on your accounts receivable. With invoice factoring, your organization sells or assigns its invoices to a factoring service. The factor then advances a percentage of the money owed, usually around 80 percent of the total. Once it receives payment of the invoice, the factor subtracts its fee from the remaining amount and pays you the balance owed.

How Does Invoice Factoring Work?

First, you have to find a factoring company and complete the application process. The factor determines whether you meet their criteria, such as the types of accounts you invoice. If approved, you and the factor sign an agreement that sets the maximum amount you can factor at any one time. Once you find a factor to work with, there are seven basic steps to invoice factoring.

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  • 1.Send your customer an invoice that is payable within 90 days.
  • 2.Submit that invoice to the factor, who determines whether your customer is a good credit risk.
  • 3.The factor pays you an advance, typically around 80 percent of the invoice amount, though this varies by industry and transaction.
  • 4.Either you or the factor sends your client a notice of assignment, which tells your client that the factor is to receive payment on the invoices you send.
  • 5.Payments go to a lockbox account, designated and arranged by the factor.
  • 6.Your client pays the factor within 90 days of receiving the invoice (or according to the invoice's terms).
  • 7.The factoring company pays you the remaining balance due, known as the reserve amount, minus their fee.

What Are the Different Types of Invoice Factoring?

There are different types of invoice factoring; each offers its own benefits.

Recourse factoring is best if your customers have a good payment record. This is because it requires you to repay the factoring company any money advanced against your invoice, as well as the factor's fees, in the event your customer does not pay their invoice within 90 days. Since the factor takes on no real risk, recourse factoring is the most cost-effective option, as well as the easiest to obtain.

Non-recourse factoring puts the risk of non-payment on the factor. If your customer doesn't pay their invoice, you still keep the advanced funds from the factor. Please note that some factoring companies include exceptions that require you to reimburse advanced funds, despite promoting themselves as non-recourse factoring companies. Read the fine print carefully before signing anything.

Spot factoring offers the greatest flexibility, as it allows you to pick and choose which invoices to factor, as well as how often.

Contract factoring sets requirements as to whether you submit every invoice from particular customers, or a given percentage of your monthly billing. Notification factoring is when the factor takes over your entire billing and collection process. This includes all billing-related communications, invoices, and collection calls. Once they purchase your client's debt, the factor sends your client a notice that the debt now lives with the factoring company, as well as how and where to make payment.

Non-notification factoring keeps communications in your company's name, but the factor handles billing and collections. Communications may include the factor's address, and calls originate from their office, but that address includes your company's name and callers typically identify themselves as employees of your billing department.

Who Uses Invoice Factoring?

Although just about any business-to-business or business-to-government company may choose invoice factoring, certain industries rely on it more than others do. This is particularly true for organizations whose working capital needs are substantial, such as:

  • Government contractors
  • Import and export organizations
  • Janitorial and cleaning services
  • Manufacturing companies
  • Oilfield services
  • Temporary and permanent staffing companies
  • Trucking companies
  • Wholesale and distribution companies

Is Invoice Factoring the Right Choice for My Business?

There is no single answer as to whether you should choose invoice factoring. It depends on your particular circumstances and situation. However, it is a viable option if your company is facing a rough patch due to slow paying clients, or because you're looking at an unusually large expense. It's also good for businesses experiencing growing pains, or if you're looking to take your business to the next level. Finally, it's a popular choice for companies that are looking to outsource their billing and collections.

Do your research and look carefully at your factoring options. It does come with a cost, so continue to educate yourself and look closely at any factoring company you're considering. Check whether there are any complaints lodged against them and look at consumer rating sites to discover what previous clients thought of their services. You can also talk to others in your industry and learn from their experiences.

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Author: Ashley Smith


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