If you own a small business that frequently issues invoices to customers and vendors, you may have encountered times when an invoice is late or goes unpaid. It can be frustrating and worrisome when expected income is unavailable, leaving your business short on cash flow for necessary expenses.
There are options like business lines of credit or short-term business loans to provide cash flow. But in this case, you might also consider invoice factoring to quickly access cash for your immediate needs. This type of financing allows you to leverage your unpaid invoices without applying for an actual loan.
Let’s walk through what invoice factoring is, how it works, and what business cases are a good fit for this type of funding.
What Is Invoice Factoring?
Invoice factoring, also known as accounts receivable factoring, is a form of small business financing in which you sell your unpaid invoices to a factoring company. The factoring company gives you a percentage of the invoice up front and pays you the rest of the invoice once it’s paid by the customer (minus fees charged by the factoring company).
With this type of financing, you no longer own the invoices — the factoring company does. As a result, it’s important to choose a reputable company that you can trust to treat your customers with respect.
What Is a Factoring Company?
A factoring company is a financial institution that purchases a business’s outstanding invoices at a discount to provide immediate cash flow. The factoring company then takes on the responsibility of collecting payments from the business’s customers.
Factoring companies can be independent firms or divisions within larger financial institutions such as banks or credit unions. They specialize in providing working capital to businesses with long receivables cycles or that need quick cash for operational expenses. By selling your invoices to a factoring company, you can receive up to 90% of the invoice value up front. The company pays you the remaining balance, minus a factoring fee, once the customer settles the invoice.
Factoring companies typically cater to industries with extended payment terms, such as manufacturing, trucking, and staffing agencies. These lenders evaluate the creditworthiness of the business’s customers rather than the business itself, making this an accessible funding option for businesses that have poor or limited credit.
How Does Invoice Factoring Work?
Invoice factoring involves selling your unpaid invoices to a factoring company, which then takes ownership of the invoices. Invoice factoring is technically not a business loan, as you are selling your invoices to the lender.
Factoring companies will pay you a percentage of the invoice amount up front, which reflects the advance rate. Advance rates are typically based on how risky the invoice factoring is for the factoring company.
Some industries, such as the medical industry, may be seen as higher risk, thus offering lower advance rates — often ranging from 60% to 80%. Other types of businesses, such as staffing agencies, may receive advance rates from 80% to 90%.
Once the factoring company receives full payment from your customers, they provide you with the remaining invoice amount minus a factoring fee.
Here’s a quick look at the steps involved in factoring invoices:
1. Choose a factoring company: It’s a good idea to shop around and pick a reputable company to work with.
2. Submit invoices: To apply for factoring, you’ll need to provide invoices for approval.
3. Receive advance: If approved, you’ll get an upfront payment (typically 60%–90% of invoice value).
4. Company collects payments: The factoring company collects payments from your customers.
5. Receive balance: After full payment is collected, you receive the remaining amount minus fees.
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Recourse vs. Non-Recourse Factoring
You might be wondering: What happens if customers don’t pay their invoices?
With recourse factoring, the business is liable for paying the factoring company for any invoices that are left unpaid. This type of invoice factoring is most common because it’s less risky for the factoring companies.
With non-recourse factoring, the factoring company takes on most of the risk associated with unpaid invoices. Since the invoice factoring company is assuming more risk with non-recourse factoring, they may tack on a higher factoring rate. Carefully consider whether the higher rate is worth the cash advance amount and compare factoring companies to see what terms they offer.
Example of Invoice Factoring
To give you a better understanding of how invoice factoring works, let’s imagine you own a clothing store that sells large quantities of T-shirts to other companies.
1. Complete sale and issue invoice: You sell $100,000 worth of t-shirts and invoice your customer with a due date in 60 days. If you wait 60 days for repayment, your business could be left with a cash flow shortage, threatening the well-being of your operation. So, you decide to look into options to help manage cash flow.
2. Explore your options: You could use an online business loan or a credit card to get cash quickly. But your customers are reliable and pay invoices in a timely manner, so invoice factoring is a suitable option.
3. Sell to a factoring company: You sell the $100,000 invoice to a factoring company and agree to pay a flat factoring fee (sometimes called a factoring rate) of 5% of the invoice value per month. Within 24 hours, the factoring company provides you with 80% of the invoice amount. You now have $80,000 to supplement cash flow and regular business operations.
80% of $100,000 = $80,000
4. Collection of funds: The customer pays the factoring company within 30 days. Once it receives full repayment, the factoring company pays you for the remaining invoice amount ($20,000) minus the factoring fee of 5%.
$20,000 – $5,000 (5% of $100,000) = $15,000 back to you
Keep in mind that this hypothetical is an example to illustrate how invoice factoring may work in a practical situation. Different invoice factoring services may offer various terms and conditions, which can affect how much money you receive up front and the final payment amount.
Invoice Factoring Rates and Fees
Invoice factoring companies generally make money through the factoring rates and fees they charge. Typically, you will see invoice factoring structured with one of the following:
• Flat rate/fee: You pay a fixed percentage of the invoice to the factoring company. The rate doesn’t usually change — even if the customer pays late. Flat rates are generally less common than tiered or variable rates.
• Tiered or variable rate/fee: A percentage of the invoice amount is regularly charged until the factoring company receives full repayment. The longer invoices go unpaid, the more you’ll owe in factoring fees. For example, a factoring company may charge a factoring fee of 1% every 10 days until the invoice is paid; if it takes your customer 60 days to pay, the factoring company would keep roughly 6% of the invoice amount. Some factoring companies may increase the variable rate the longer repayment takes.
Factoring rates and fees can be affected by:
• The industry your business is in
• Your customers’ ability to pay their invoices
• The number and amounts of the invoices
• Your business’ stability and creditworthiness
Additional Fees
Some factoring companies may also charge additional fees, including:
• Application fees. These are charges for processing your application and setting up the account.
• Invoice processing fees. These fees help cover the cost of things like credit checks and record keeping.
• Service fees. These are charged in intervals to cover costs related to maintaining a current account with your factoring company.
• Automated Clearing House (ACH) or bank wire fees. When funds are transferred between banks, there may be fees passed on to you from the factoring company.
• Early termination fees. Some invoice factoring companies may charge a fee if you cancel your contract before the termination date.
• Due diligence fees. This covers the cost of verifying the creditworthiness of the customers paying the invoices.
Invoice Factoring vs. Invoice Financing
While they sound similar, invoice factoring and invoice financing are two different financial products.
With invoice financing, your invoices are used as collateral to receive a cash advance rather than sold to a factoring company. You receive access to a percentage of the invoice amount either in the form of a line of credit or loan. Like other types of business loans, you pay interest on the amount you borrow.
Another key difference between invoice factoring and invoice financing: With invoice financing, you and your business are still responsible for collecting payment from your customers. As a result, invoice financing allows you to retain control over your invoices and the collections processes, which may be more favorable if you prefer to deal with your customers directly.
Pros and Cons of Small Business Invoice Factoring
Invoice factoring can be a useful tool for business owners in certain situations. However, it’s important to carefully consider the pros and cons of factoring invoices to avoid unnecessary expenses or added stress for your business.
Pros of Invoice Factoring
• No collateral: With invoice factoring, your invoices serve as collateral. In most cases, you do not have to offer additional forms of collateral to be approved.
• Maintain healthy cash flow: You can receive immediate cash to cover expenses and maintain healthy cash flow between invoice payments.
• An option for those with lower credit scores: Even if you don’t have good enough credit to get a business loan, invoice factoring may still be an option. Invoice factoring companies generally focus more on the value of the invoices and the credit scores of the businesses that owe those invoices than on the credit score of your business.
• Outsource invoice collection: FFor some businesses, it may be helpful to pass the responsibility of collecting invoices to a factoring company so they can focus on other responsibilities.
• Spend on what you need: Unlike other types of small business loans (e.g., equipment financing), you aren’t restricted to spending the funds you receive on specific business expenses.
Cons of Invoice Factoring
• Factoring companies have control: After you sell invoices to a factoring company, they may interact with your customers directly. You’ll want to make sure that the company is reputable and behaves ethically in their dealings with customers.
• It’s typically expensive: With various fees and relatively high rates, invoice factoring can be costly — especially if customers delay payment.
• Recourse if unpaid: Since there’s no guarantee that an invoice factoring company will be able to collect on unpaid invoices, they may expect you to pay for or replace the invoice, possibly with additional fees.
• Approval may depend on customers: Invoice factoring companies want to ensure they will receive payment on the invoices they purchase from you. If your customers have a less-than-perfect repayment history, you may have a more difficult time getting approved.
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How Do Businesses Qualify for Invoice Factoring?
Factoring companies evaluate a few different things to determine if a business is eligible for this type of financing.
• Invoices: Businesses must have outstanding invoices to sell to a factoring company, and the invoices should be from reputable clients with a history of timely payments.
• Client creditworthiness: Factoring companies focus on the likelihood of timely payments from your clients rather than the credit history of your business. Therefore, clients that consistently pay their invoices on time are a must.
• Business bank account: An established business bank account is essential to qualify for invoice factoring. Your business bank account will be used for the factoring company to deposit the advance and the remaining balance once the invoice is paid.
• Accounts receivable reports: Detailed and accurate accounts receivable reports are necessary to demonstrate your business’s invoicing practices and the payment behavior of your clients. These reports help factoring companies assess the risk involved.
While the primary focus is on the creditworthiness of clients, factoring companies also look for signs of business stability. They consider factors like time in business, industry, and overall financial health. It’s also important for businesses to ensure there are no existing liens on their receivables. Factoring companies need a clear right to collect on the invoices, so any existing liens or claims can disqualify the business.
You can improve your chances of qualifying by maintaining good relationships with your clients, ensuring they are creditworthy and have good payment histories. Keeping financial records organized and accurate is also important, as it makes the evaluation process smoother and faster.
Alternatives to Invoice Factoring
Invoice factoring is one of many options that can help businesses maintain cash flow and address funding needs. Here’s a look at some alternatives.
• Inventory financing: This type of financing is used to pay for products that will be sold at some time in the future. The inventory acts as collateral for the loan.
• Equipment financing: This is a type of loan used specifically to purchase machinery, vehicles, or other business-related equipment.
• SBA loans: These are small business loans backed by the U.S. Small Business Administration (SBA) and offered by banks and approved SBA lenders.
• Personal loans: An unsecured personal loan is based on your personal credit history (not business credit). Some, though not all, lenders will allow you to use funds from a personal loan for business expenses.
• Commercial real estate loans: This type of business loan is specifically designed for purchasing real estate for business use, such as an office space, warehouse, or storefront.
• Business line of credit: With this flexible form of business financing, you have access to a maximum amount of funding, or credit. You can borrow what you need (up to your credit limit) as you need it, and only pay interest on what you borrow.
• Online business loans: Online lenders offer loan options similar to those traditional banks offer but typically have a faster approval process and may have more options for people with lower credit scores.
• Merchant cash advance: This type of funding allows small businesses (“merchants”) to get a cash advance for business expenses in return for a portion of their future sales or receivables.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What are the disadvantages of invoice factoring?
The disadvantages of invoice factoring include high fees, potential impact on customer relationships, loss of control over accounts receivable, and the requirement of having creditworthy clients.
What is the average rate for invoice factoring?
The average rate for invoice factoring ranges from 1% to 5% of the invoice value per month.
Who can use invoice factoring?
Generally, any business with outstanding invoices and creditworthy clients can use invoice factoring. However, this type of financing tends to be more common in industries like manufacturing, trucking, and staffing.
Photo credit: iStock/Jirapong
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