How Invoice Factoring Works
Before we jump into invoice factoring, it's important to point out that invoice factoring is different from invoice financing. The two are commonly lumped together, which can create lots of confusion. Read about the differences here.
So what is invoice factoring?
Invoice factoring lets companies sell their invoices for cash. This can be beneficial when cash that is used for working capital is short. Without working capital, companies can't pay their creditors, employees or suppliers. Basically, at some point, the business will come to a grinding halt.
Invoice Factoring is a service provided by a company called a factor. The factor buys outstanding invoices and handles the collection of payments from customers. The factor advances 70% - 95% of the paid amount of invoices to the business. The remaining amount is held by the factor. Once the factor collects payment from customers, the balance held is paid to the company minus the factor's fee.
When a company sells all of its invoices to a factor, this is called "whole ledger factoring." When they instead choose to sell a single invoice, it is called "single invoice discounting" or "spot factoring."
The main reason a company will use invoice factoring is to help cover a short-term cash flow shortage. This is in contrast to using such a service to finance ongoing operations. Learn more about what invoice factoring means here.
Types of Invoice Factoring
There are generally two types of factoring that business owners can choose from - spot and contract.
Spot factoring is also known as single-invoice factoring. It allows the business to factor just a single invoice rather than multiple invoices.
Contract factoring also called high volume factoring, is the more common form of factoring. In this scenario, business owners process most or all of their invoices with the factor.
Fees vary across both invoice factoring models. Spot factoring is higher fees than contract factoring. With spot factoring, the factor doesn't really have the necessary time to get for getting to know your business and customers. This means the factor is taking on additional risks that aren't there with contract factoring.
Spot factoring can involve a number of one-time fees. These can include wire or ACH fees, startup fees, and overdue fees.
Contract factoring also involves one-time fees, but it is overall a long-term relationship with the factor. Once you pay the initial fees, you don't have to pay them again as long as you are still in the relationship with the factor. With spot factoring, you'll have to pay one-time fees with each invoice.
Non-recourse factoring is another type of invoice factoring that is very rare. With this type of factoring, you do not need to purchase the invoice back from a customer who is unable to pay. While non-recourse factoring is rare, it is even rarer for spot factoring.
Invoice Factoring for Cash Flow Issues
If a company is selling products and invoicing its customers, how does it get into a situation where there isn't any cash? Aren't customers paying for these products?
Yes, but depending on the industry, customers often have 30, 60, or 90 days to pay an invoice. Meanwhile, the company might use up all of its cash just to keep the business running. With no cash coming in from customers for a month or more, this creates a cash flow shortage.
This is where invoice factoring can help, especially for startups that are notoriously short on cash.
Invoice factoring can help both established companies and startups fill their cash flow gap. The turnaround on invoice factoring is fairly quick. Companies are often paid within only a few hours to a few days. This makes invoice factoring a popular choice when cash is needed immediately.
Navigating Invoice Factoring Rates and Fees
When it comes to invoice factoring rates, if you have a high volume of low-risk transactions, you'll get a good invoice factoring rate and if you have a low volume of high-risk transactions, you'll get a higher invoice factoring rate.
Another aspect to consider is that invoice factoring rates are determined by how big of a risk you are to the factoring company. The factor will evaluate your risk potential by looking at the following:
- Monthly factored volume
- Size of each invoice
- Creditworthiness of clients
- Age of business and type of sales
In general, a factor's fee structure will include the following:
- Factoring fee ranging from 3% to 8%
- Fixed processing fee
- Initial fee to set up the contract
- ACH/Wire fees
- Overdue fees
There can be a number of other fees and penalties that can be involved. This is why reading the fine print is to your advantage. Some factors may charge a penalty if you get out of the contract early. If a customer is unable to pay, you might be required to buy back the full invoice, even if you were already advanced 90% of its value. There can also be a penalty for not meeting the monthly minimum as outlined in the contract.
Some factors may have a flat fee structure. Under this arrangement, you pay a fixed fee no matter how long the invoice remains open. In some cases, a percentage-based rate and a flat fee may be offered. This depends on the industry and your company's risk level, as determined by the factor.
Let's look at some examples of invoice factoring rates to get an idea of what might constitute a better rate. Here are two different rates along with their terms:
- A 75% advance at a rate of 2.50% per 30 days, or
- An 80% advance at a rate of 3.00% per 30 days
How to calculate each invoice factoring rate:
- .025 / .75 = $0.0333
- .03 / .80 x 100 = $0.0375
The first example gives us a cost per dollar of 3.33 cents while the second is 3.75 cents. At first glance, the difference is only 42 cents. However, that's equivalent to a 12.71% spread, which can add up quickly.
The Impact of Invoice Factoring on Your Customers
When you sell your invoices, you give up the management of payment collection with your customers. The factor will take over and handle the collection of invoices from your customers. This means you're giving up a level of control and is a big consideration when thinking about whether factoring is good for your business.
Once the factor takes over, customers will know. They receive a Notice of Assignment that lets them know what is going on.
It also means your customers should be ok with the arrangement. At the least, you'll want to let them know what is happening so they aren't caught off guard.
Advantages of Invoice Factoring For Your Business
The biggest advantage of invoice factoring is that it can fill a cash flow shortage immediately. If you have outstanding invoices, rather than waiting 60 to 90 days for payment, the factor can advance payment to you immediately.
You also do not have to take on debt. Invoice factoring is not a loan and no debt will show up on your balance sheet. It's your cash. You are simply making arrangements to receive it sooner than usual.
In some cases, business owners might turn to equity investors to help them build up cash and plug cash flow holes. Equity investors will often expect a return on capital that is much higher than that of accounts receivable factoring. The factor will take care of payment collection from customers. This frees up your time to focus on business operations.
1. Quick Access To Cash
When cash is needed immediately, invoice factoring can meet the need. Because the approval process is very easy and fast, you can have your advance in just a few days.
2. No Additional Debt
You don't have to worry about adding more debt to the balance sheet. Invoice factoring is similar to a credit line rather than a traditional loan.
3. Flexible Terms
Once you're set up with a factor, use their services when you need them. There's no charge for not using their services.
4. Offloading Collections
Let someone else handle your invoice collections and all the administration that goes with it. This will free you up to focus on deploying cash and growing your business.
5. Don't Need Strong Financials
If you are a startup or don't have the best financials, this will usually not affect your ability to get invoices factored. It's your customer who needs to pay the invoice, not you, and that is what the factor will look at.
6. Collateral Isn't Required
Because you aren't taking out a loan, you don't need to put up collateral.
7. With More Factoring Comes Lower Fees
As the volume of your factoring goes up, say from $5000 to $15,000 per month, your rates will come down. This will increase cash flow as more of the overall invoice amount is returned to the company.
Disadvantages of Invoice Factoring For Your Business
Invoice factoring costs more than traditional loans. Due to its transactional nature, factors must verify every invoice and ensure customers are creditworthy. This is a labor-intensive process.
Cost can vary widely between factors, so it's important to shop around for the best deal. Factors may also charge based on different fee structures. This can make comparing factors difficult.
Factoring arrangements can become complex. Some factors may charge based on transactions while others may charge based on a percentage of outstanding invoices. It isn't uncommon to find factors whose fee structures use both methods.
When working with a factor, you give up control of payment collection since accounts receivable is assigned to the factor. This means that your customers' accounts payable departments will be notified that any payment should be directed to the factor.
If third-party payments are uncommon in your industry, you might want to let customers know what is happening so they fully understand the relationship with you and the factor going forward.
1. High Cost
Invoice factoring costs can be high and are usually much higher than that of a traditional loan.
2. Customer's Perception
Customers may perceive problems with your company.
3. Invoices Need To Be Verified
Factors will want to know if the amounts on invoices are accurate and customers are satisfied with the products or services they've received.
4. Only Commercial Invoices Only
Some factors may restrict invoices to
How To Choose An Invoice Factoring Company
A 2017 survey by factoring.org found that 25% of factors have been in business 5 years or less with 37% having been in business for 16 or more years.
When choosing an invoice factoring company, experience, as well as reputation, is a top consideration. It's important to do all the research you can about any factor you are considering. There are likely to be articles on the Internet about the factor that can help reveal customer experiences or additional information on how the factor operates.
When choosing an invoice factoring company ask yourself the following questions:
- What does your own experience tell you?
- Is the company forthcoming with answers?
- Does the factor respond in a timely manner?
- Is the factor willing to negotiate on the rates and contract terms?
- Does the company offer any type of system that lets you track payment collection progress without having to call or email the company to get updates?
Invoice factoring is meant to solve a short-term problem, not be a long-term solution. If cash flow shortages are occurring more frequently than you'd like, seeking out solutions that can handle longer-term financing is a better option.
If your company is considering an invoice financing or factoring solution, it may be time to consider something even better. Apruve can help you set up a trade credit and A/R automation program for your business buyers, extending your working capital, driving internal operational efficiencies, and enhancing the buyer experience. Learn more about Apruve or contact Apruve’s specialists to sign up for a demo today!