What is Invoice Factoring?
First, let's answer the obvious question: what is invoice factoring? In its simplest terms, invoice factoring describes the sale of unpaid invoices to another company as a means of covering debt and problems caused by slow-paying customers.
This neatly brings us to our next question: what is a factoring company? In this case, it's the company that agrees to buy the unpaid invoices. We'll cover the first question - what is factoring in business? - in greater detail as we progress through this tutorial.
How Does Invoice Factoring Work?
Invoice factoring is a way for small businesses to recoup debts quickly and may be especially useful for companies experiencing bad credit. In that sense, it helps to think of invoice factoring as invoice loans. Invoice financing companies also offer related products like invoice discounting and secured lending.
As mentioned, though, the best invoice factoring companies will lend capital to your company against your unpaid customer invoices. The lender is known as the 'factor' and will usually only purchase from you at a discount of around 10-30% of the invoice total.
What Industries Does Invoice Factoring Work Within?
While small business invoice factoring is available in many industries, some sectors definitely see more activity from accounts receivable factoring companies. These industries tend to be those that have high start-up costs, low initial income, and long invoice payment terms (30-90 days) such as transportation, freight, and anything that involves heavy machinery, like clothing, manufacturing, and technology.
The invoice factoring rates your company is offered may vary depending on your industry but accounts receivable factoring is not as exclusive a product as bank loans can be.
What’s in the Factoring Agreement?
In brief, a lot. An invoice factoring agreement can be around ten pages long. However, before you receive an official agreement, you'll be sent a non-binding proposal from the factoring company. If accepted, the agreement that follows will include details such as the invoices being sold, any commission added by the factoring company, termination details, and your company's obligations under the factoring arrangement. You may ask to omit certain invoices from factoring.
You must also notify all customers whose invoices are now payable to the factoring company of the agreement.
An invoice discounting agreement is very similar to factoring but customers do not need to be told about the sale of their invoices.
What is Needed to Start Invoice Factoring?
I've found small business invoice factoring to be as involved a process as many other financial products, so you'll need to collect all the relevant documents before applying. You may also require a guarantee from a senior employee (such as a director).
Firstly, your company must meet the basic requirements to be considered a business. It should trade with customers and other organizations and issue invoices on accounts payable. There may also be restrictions placed on your business' turnover amount and monthly invoice quantity by the factoring company.
As far as documentation is concerned, be prepared to hand over customer details, financial records, and your company's sales ledger. Remember, too, that invoice factoring companies must recoup invoices to avoid losses, so evidence that this is possible may be required.
Credit Considerations
Unlike bank loans, small business invoice factoring can be arranged with poor credit and even court judgments on your credit file. You may also be able to acquire capital without harming your credit score. However, your clients and/or customers must pay their invoices to the factoring company or your agreement can affect your ability to apply for financial products in the future.
Invoice Factoring Pros and Cons
Perhaps inevitably, we've discovered that receiving invoice finance can be a mixed blessing. Here are just a few of our observations:
Pros:
- Low requirements for acceptance
- Cash can be acquired immediately
- Acceptance may not affect your business' credit file
- Financing on invoices is unsecured
- Available to small businesses earning $20,000/month
- Capital can increase as invoice quantity does
Cons:
- The company loses control of invoicing
- A history of non-paying customers can reduce your chances of approval
- 1-5% of each invoice is payable to the factoring company
Main Factoring Rates & Terms
Invoice factoring can be expensive but rates are variable depending on the following factors: industry, invoice size and volume, average customer credit rating, and the payment terms offered to clients (e.g. how long they have to pay). Once all the previous have been considered, invoice factoring rates generally fall in the region of 1-5% of each invoice sold.
As we've mentioned earlier though, the success of capital raised on invoices depends on the ability of each customer to pay, and small business invoice factoring companies will generally add fees for late payment, such as 0.5% for every ten days unpaid.
We often get asked questions about rates per industry - such as what is factoring in trucking? However, it's not always possible to answer this question without all the information outlined above.
actoring Invoices Average Cost
- 1-5%, with penalties for late payment.
Calculated Cost
- For an 80% advance on $100,000 of unpaid invoices, our hypothetical company receives $80,000. At a rate of 5% from the factoring company, the business will have to pay $5,000 in fees.
Factor Advance Rate
- Advance rates vary from 10-30% of the total unpaid invoices. In our previous example, the advance rate is 20%.
Full Funding vs. Partial Funding
- Full funding means that the factoring company gives up the full value of the invoice, minus advance fees, immediately. Partial funding means that the receiving business only gets a portion of each invoice's cost until the client or customer pays up.
Important to Take into Consideration
One of the values that I've tried to instil in my team members is that it's important to know all the details of a financial product up-front, however insignificant they may appear to be at the time - and small business invoice factoring is no different. Let's take a quick look at a few of the particulars you should keep an eye out for.
Industry
- As the cost of machinery and staffing (for example) varies across businesses, note that your trucking company may pay more or less for invoice factoring than the apparel factory next door.
Invoice Volume
- Invoice factoring companies may stipulate that your company must issue only X invoices over Y days or months - and this may be written into the terms of your agreement. If you expect your company to grow, be sure to take this into account before signing any documents.
Invoice Terms
- Again, the terms you provide to your customers may influence your decision to sell your invoices to a factoring company. Short invoice turn-around times (e.g., seven days) are not really suitable for invoice factoring.
Type of Service
- There are a number of invoice financing products available, including factoring, discounting, and secured loans.
Type of Clients
- The number and type of clients you work with can determine your chances of being approved for invoice factoring. Slow or non-paying customers or those with a poor credit history can prove fatal to an application.
Invoice Financing from the Lender's Perspective
Invoice finance lenders loan money to a business on the condition that capital can be recouped from the company's unpaid invoices. With that in mind, invoice factoring can be a risky undertaking for a lender. This is why agreements require the loanee to surrender their invoicing in its entirety to the financing company.
Invoice factoring companies, ideally, want to work with organizations that have a proven record of receiving prompt payments from customers, with few in default or in a precarious credit situation.
