What is invoice factoring?

Invoice factoring is a type of financing used by businesses to improve cash flow and cover operating expenses. It involves selling unpaid invoices to a third party, called a factor, at a discount. The factor then collects the full amount from the customer at a later date. Invoice factoring allows businesses to access a portion of the cash tied up in accounts receivable immediately.

How Invoice Factoring Works

The invoice factoring process involves three main parties – the business selling the invoices, the customers who owe money on those invoices, and the lender who purchases the invoices.

Here are the typical steps:

1. A business generates invoices for customers as goods or services are delivered. These invoices have payment terms outlining when the customer needs to pay in full, usually in 30, 60 or 90 days.
2. The business sells these unpaid invoices to a factoring company at a discount, usually ranging from 1-5% of the total invoice amount. This provides the business with up to 90% of the invoice value immediately.
3. The lender now owns the right to collect payment on those invoices directly from the customers. The payment from the customer directly goes to the lender.
4. Once the lender receives full payment on the invoices from the customers, they pay the remaining balance, minus their fees, to the business.

Essentially invoice factoring allows businesses to convert unpaid invoices into immediate cash flow. It accelerates access to working capital tied up in the collection cycle. Factoring fees and discounts effectively become the “cost” of getting accelerated cash flow.

Types of Invoice Factoring

There are a few different types and variations of invoice factoring to meet different business needs. The core types include:

1. Recourse Factoring – With recourse factoring the business retains some of the risk of non-payment by customers. If a customer does not pay for any reason, the factor can claim the uncollected amount back from the business at a later date.
2. Non-Recourse Factoring – Non-recourse factoring transfers the entire credit risk to the factoring company. They have no claim against the business for non-payment by customers. This protects the business, but also costs more.
3. Disclosed Factoring – Disclosed factoring means that customers are notified and made aware that invoices have been sold to and are now payable to the factoring company. This is standard practice.
4. Undisclosed Factoring – Undisclosed factoring hides the assignment of invoices from customers, maintaining the perception that they are still paying the original business. Setup costs are higher, but some see a benefit in masking third party involvement.

Typically invoice factoring runs on 1-5% in fees (this is not APR), plus interest on advancing the cash.

Invoice Factoring vs Business Loans

Invoice factoring differs quite a bit from traditional small business loans and lines of credit. Factoring only works for businesses that generate invoices, generally for other businesses.

Here are some of the major differences:

1. Approval – Factoring decisions focus on the quality of invoices and customers. Lenders scrutinize the overall business performance and creditworthiness. Invoice factoring has higher approval rates. Having a history of paid invoices and a regular volume is important.
2. Flexibility – Factoring scales with sales volume without fixed payments. Loans involve fixed terms and scheduled installment payments regardless of cash flows.
3. Documentation – Factoring looks directly at sales invoices with lighter documentation. Loans require extensive financial statements, projections, and detailed documentation.
4. Collateral – No personal guarantees or liens on business assets are required for factoring. Banks secure loans against the assets or equity of the company and owners.
5. Cost – Factoring rates and fees tend to compare favorably with short term financing options like merchant cash advances, significantly lower than small business loans longer duration.

Invoice factoring provides extremely flexible working capital and funding for growth. Business loans deliver large lump sums of capital, but with stricter terms that may bind high growth companies. The positive trade off with factoring is avoiding new debt obligations and keeping ownership of the business assets free and clear.

What are the variables that impact factoring discount rate

Factoring companies use several variables to assess transactions and price their funding rates:

1. Credit Quality – The credit profile of customers owing payment on invoices is a major criteria. Companies with strong commercial credit are favored.
2. Invoice Duration – Invoices with 90 day terms cost more than 60 day terms and so on. The longer timeframe the factor has to wait for payment, the higher the rates. The rates are charged as a percentage of the invoice (not an APR).
3. Industry Types – Industries like construction pose more payment risks, while repeat manufacturing sales may be very reliable. Higher risk sectors often factor at higher rates to offset losses from non-payments.
4. Sales Volume – More transaction volume lowers costs by distributing fixed overhead across a larger pool of invoices, and improving loss ratios. Large invoice pools factor cheaper on a unit basis.

In addition to factoring rates set using the above criteria, fees also apply for processing and other admin work. Fees often come in around 1-3% of the total invoice value.

All said, costs typically stack up between 3-5% for general factoring. Rates as low as 1%, or as high as 15% are possible depending on the provider, services desired, industry factors, and the overall risk level of the transactions.

Conclusion

Selling outstanding unpaid invoices enables immediate access to cash tied up in receivables. For newer high growth companies it represents working capital to fuel expansion in lieu of expensive and difficult to get loans. Factoring also avoids adding risky debt obligations that could jeopardize ownership of the business.