Invoice factoring is an invoice finance facility designed to support businesses in maintaining a healthy cash flow. For many firms which invoice customers with payment terms, it is often not possible to reconcile their incomings and outgoings to avoid cash flow issues (giving even profitable businesses the feeling of being cash-poor). Without a pot of working capital, companies often find themselves stuck in a tight spot, unable to invest in new projects, hire new staff, or grow.
So how can businesses solve this problem? This where invoice factoring comes in as a type of asset-based lending based on money soon coming in. It relevant for any business that invoices its customers with extended payment terms. Instead of waiting weeks or months to see any cash, this source of finance enables you to access the funds in the form of a loan almost immediately, for a fee. This guide will take you through all you need to know about invoice factoring in the following sections:
- What is invoice factoring?
- How does it work?
- Advantages & disadvantages of factoring
- Is my business eligible for invoice factoring?
- How much does factoring cost?
- Choosing an invoice factoring company
- List of invoice factoring companies
- Frequently asked questions
- Final thoughts & case study
What is invoice factoring?
Invoice factoring is a form of invoice finance. Factoring is often confused with invoice discounting. Both terms refer to forms of invoice-backed finance, where a company sells their invoices to a third-party, who will provide you with a cash advance typically within a few days, and the remainder once the customer pays the invoice, minus a fee.
The principal defining invoice factoring lies in the control of the sales ledger. With factoring the lender takes control of your sales ledger and collects the payment directly from your customer (with discounting the control of the ledger and customer communications regarding invoices remain with the business).
For finance providers, this type of lending is low risk. The customers owe the money they are lending, meaning it’s highly likely that the financiers will see their finance returned. For businesses, this upfront capital releases the pressure of untimely cash flow, releasing funds tied up in unpaid invoices. Bills can be paid immediately, mitigating damage from late-paying customers. For companies looking to grow, this form of finance can be invaluable as a way to access cash at a convenient time, using it to invest and grow without the fear of a cash flow shortfall.
It can be helpful to think of invoice factoring as a business loan. Your unpaid invoices, or accounts receivable, act as your collateral. This form of borrowing is sometimes known as accounts receivable factoring.
Is invoice factoring confidential?
Invoice factoring is typically disclosed. The central premise of factoring means that the lender has control of the sales ledger and is responsible for chasing payment, which means that in the vast majority of cases, the use of a third-party is public.
However, in rare cases, it is possible to use confidential invoice factoring. The factor still controls the sales ledger but acts as your company’s accounting department under your company name, rather than using its own name. This option is useful for companies who don’t want to put their reputation at risk by informing their customers of third-party involvement, but that would like to outsource the control of the sales ledger.
How does it work?
A business sells its unpaid invoices to an invoice factoring company which pays the value of the invoices in two instalments to the business, minus their fee. The business receives the first instalment very quickly after the finance provider receives the invoice, usually within 24 hours. This instalment is typically 80% of the value of the invoice and will appear as a deposit in the businesses bank account. The business can then use this working capital straight away to pay bills, pay staff, invest in new materials or expand.
The second instalment arrives once the customer has paid the invoice factoring company. This point is key. If you use invoice factoring, rather than your customers paying you, your lender will take over your sales ledger. Your customers will be aware that you are using a third party, and will have to pay into an account controlled by the factoring company. The factoring company will be in charge of credit control procedures, including chasing non-paying customers.
The control afforded to the lender is where invoice factoring differs from other forms of invoice finance. While relinquishing control can remove some of your company’s responsibility and costs, it can have other impacts, which we’ll take a look at later.
Advantages & disadvantages of factoring
There are a number of pros and cons which come with invoice factoring. The following weighs up the positives and negatives of this form of finance to help you decide if it’s the right financing solution for your business.
Invoice factoring is a uniquely efficient way to secure considerable sums of money quickly. Mmost invoice factors will provide you with your advance within 24 hours of an invoice being created. It’s easy to set up, with most providers approving applications within a week.
No need for security
Unlike more traditional forms of lending and borrowing, there’s no need to put up any additional security beyond the invoice being factored (unless otherwise agreed). The financier knows that your customers are obliged to pay their bills, meaning the outstanding invoices serve as collateral themselves.
External debt collection
Invoice factoring is unique in that the lender almost always assumes total responsibility for debt collection. It’s in their hands to chase late-paying customers and deal with demanding clients refusing to pay. This alleviation can free up valuable time and resources in your company, to be directed to other ventures or plans for growth.
Invoice factoring is also typically a lower-risk form of borrowing, both for your business and for the lender. As a business owner, you are safe in the knowledge that the money you owe is coming in in a matter of weeks or months, removing the pressure of taking on a long-standing debt.
For the lender, they can see where their money is coming from, and they have control over chasing the customers and having their money returned. A lower risk for the lender means this form of finance is typically cheaper than other short-term finance options available on the market, such as business overdrafts.
Factoring is also a flexible form of finance. As your sales ledger expands, or even if it contracts, it’s quick and easy to change your factoring facility to match.
Many clients are naturally distrusting of third-party involvement, and with invoice factoring, there’s not usually a way to hide it. Customers are required to pay the lender directly.
Such involvement can damage your customer relationships, which is worth weighing up when it comes to key clients. It’s also a good idea to vet your lender’s collection methods, to see how obtrusive they are when it comes to chasing or communicating in regards to invoices.
Higher fees than discounting
As the factor assumes control of your sales ledger, they’re also taking on more work, which typically translates into increased costs you pay.
Exclusion from other finance – Borrowing in this way can exclude you from other forms of finance. If you’re receiving invoice factoring, you may be ineligible for different types of borrowing, so it’s worth considering whether you can manage without other sources of finance.
Invoice factors typically offer long-term contracts. Some contracts may lock you in for 24 months or more, with significant early termination fees. Many contracts oblige you to sell all of your invoices to your factor, even in periods where you aren’t experiencing a cash flow shortage.
Using factoring in times where you may not truly need it means that you could be unnecessarily losing profits, owing to the factor rate, services fees and any additional charges. Invoice factoring can, therefore, be unsuitable for businesses with seasonal fluctuations that are able to manage their cash flow in busier periods.
Is my business eligible for invoice factoring?
More and more factoring companies are appearing, offering this form of finance. It’s often an effective solution for small businesses and startups, as well as more established companies. Your businesses eligibility for invoice factoring will largely depend on:
- who your customers are
- how large their invoices are
- the time frame on their payment terms
- the industry in which you operate.
These factors enable the lender to figure out is how much risk there is for them in factoring an invoice/s (how likely it is that customers won’t pay their invoices). For this reason, the credibility of the businesses owing is more significant than the credit rating of your own company.
Dealing with credible clients, such as governmental organisations, larger companies or firms with a good credit history, is likely to work in your favour when it comes to securing an invoice factor.
What if my business has poor credit?
Unlike other forms of finance, the risk for the lender comes from your customers rather than from you. So, the real question here is, are your customers creditworthy? If your customers have a good credit rating, this minimises the risk of non-payment.
This model of invoice lending means invoice factoring is available to many companies with poor credit, who may have been refused other types of borrowing in the past. Using invoice factoring can even boost your credit score over a more extended period.
What industries typically use factoring?
Invoice factoring is particularly used by businesses in industries with inherently long payment terms, or for companies that rely on several large customers, where one late payment can throw their entire month’s cash flow off balance.
To give you a practical idea of who uses invoice factoring and why, the following are examples of industries and situations where this type of finance is commonly used.
Printing and publishing
Late payments are inherent to the publishing industry. Getting a book or a magazine to print involves a lengthy chain of events. Each stage is reliant on the previous one, making it a challenging industry to navigate when trying to maintain healthy cash flow. Invoice factoring can remove the financial pressure for publishing businesses, meaning printing firms can take on more clients and grow their business without worrying about short term cash flow problems.
Food service companies
Many food service companies are accustomed to waiting 30 to 60 days for clients to pay their invoices. This delay is particularly problematic for smaller food service companies looking to expand. A lack of working capital prevents such companies growing and can run some companies into serious financial problems. Invoice factoring can provide an advance on slow invoices, allowing companies to pay their food suppliers, staff and safely bid for new contracts.
Many professional services offer credit terms to their clients, leading to significant payment gaps of up to 90 days, which is often the case for law firms. For commercial law firms, it’s essential to maintain a good rapport with customers to secure their future business, which means many legal firms are hesitant to harass their clients for speedier payment. Thus, invoice factoring can act as a temporary stop-gap for law firms and removes the pressure of hurrying valuable slow-paying clients (though invoice discounting is likely more suitable in this type of situation, where managing client relationships carefully is key).
Maintaining a transport business is a juggling act. Bills and costs crop up throughout the month; on top of payroll pressures and paying suppliers, there are the added costs of fuel and vehicle maintenance, which can be unpredictable. Invoice factoring can free up cash tied up in unpaid invoices, meaning transport companies can use this cash injection to invest in medium to long term growth strategies.
Aside from the above, other common industries that use invoice factoring include recruitment, manufacturing, wholesale and distribution, trade services and retail. Unlike other forms of invoice finance, it is practical for and popular among small businesses and larger businesses alike.
How much does factoring cost?
There are two main fees involved in invoice factoring: the discount charge, and the service charge. The discount charge works in the same way as interest on a traditional bank loan, applied on the advance you receive from your invoice factor. It’s the fee that the factoring company charges on a weekly or monthly basis, in return for borrowing money. Typically, the discount charge is a percentage of the invoice value, from 0.5-5%.
The service charge covers the running of your factoring facility, including costs for credit management, payment collections and general admin. Service charges are typically 0.75-2.5% of your annual turnover.
How much you pay may seem straightforward, but it’s crucial that you keep an eye out for any additional fees (such as a contract termination fee). The following additional charges you should keep an eye out for as they are typical in factoring contracts:
- a setup fee, to cover the cost of initiating your factoring facility
- minimum usage fee – you may receive a charge if you don’t fulfil a specific volume of invoices per month
- extension fees – if you want to increase your facility, you may incur a charge
- administration fees – this can cover the cost to the factoring company of auditing your business documents
- early termination fee – if you want to leave your contract early or if you don’t provide enough notice, you may be liable to pay a termination fee.
It’s a good idea to discuss all charges with potential factoring companies before making a decision, ensuring all fees are explicit and transparent before you sign an agreement.
What factors affect fees?
Factoring companies will offer you fees base on several factors.
Volume and size of invoices
The more invoices you offer a factor, usually the lower rate you’re likely to pay because an increased volume means a more consistent stream of revenue for the factoring company (meaning they can reduce the fee). In addition, owing to the factor’s credit control over your sales ledger, the facility becomes more cost-effective when it has more invoices to control.
On top of this, the larger the invoices, the better. Invoices with a larger value typically reduce the processing fees for the factoring company. Generally speaking, the lower risk your company represents and the higher the volume of invoices you want factoring, the lower the rate you will have to pay.
Some industries are riskier by nature. Labour-intensive industries such as construction tend to carry a higher risk, as there’s more to go wrong. Project completion dates change regularly, and there are lots of dependent variables at play in each project. This uncertainty translates into varying payment dates, which poses a higher risk for the lender. If the lender perceives your industry to be high-risk, your fees will reflect that.
Your trading history
Invoice factoring companies will want to see your trading history, complete with your financial statements. The less profitable your business, or the lower annual turnover it has, the higher the risk it represents to the lender, typically resulting in higher factoring costs.
Invoice payment terms
The longer your customers have to pay their invoices, the higher your fees. In practical terms the discount charge will be higher, discount charges typically work on a 30-day basis, meaning you may have to double or even triple them for 60- or 90-day payment deadlines.
It’s also important to note the longer the payment terms, the longer your lender has to wait to see their money returned. Lenders have to juggle their own cash flow, too, and the longer the payment period, the bigger this challenge – thus the higher the fee.
Recourse or non-recourse factoring
An invoice factoring agreement with recourse means that lenders are protected if your customers default on their payment. Despite invoice factors assuming control over your sales ledger, a contract with recourse generally means that you remain liable for non-paying customers. A non-recourse agreement means that your lender takes the hit if a customer cannot pay. Non-recourse contracts are more expensive, but the increased cost may be worth it if your invoices are typically large and you want to minimise your risk from non-paying clients.
A non-recourse clause is also known as Bad Debt Protection, where the invoice financier absorbs loss from customers who fail to pay (in effect a form of business insurance). Make sure to carefully check the wording if you agree a non-recourse clause to ensure it covers your business.
Lower rates don’t always equal lower cost
It’s a common misconception that lower rates result in a lower overall cost. Lower discount rates and service fees do not always translate to a lower price per pound. To get an idea of the cost per pound.
For instance, your invoice is worth £1,000. Two separate factors offer you different rates. The first offers you 80% advance at a rate of 3% per 30 days. The second offers you 85% advance at a rate of 3% per 30 days. While the first has a cost of 3.75p per pound, the second offer costs 3.53p per pound, showing that despite having an equal discount rate, the two offers have differing prices.
Choosing an invoice factoring company
Once you’ve decided invoice factoring is the right financing option for your business and have found potential lenders, it time to choose the one for you.
Choosing a lender can be a time-consuming process but its well worth carrying out thorough research to find the provider and invoice factoring facility for your business. When choosing a factor you should consider the following points:
- Reputation: is the factor credible? What are their clients saying about them? Read online reviews and find them on comparison websites to see how they fare against their competitors
- Recourse or non-recourse: more on this later. Weigh up the pros and cons of each; while it can massively reduce the pressure to opt for non-recourse factoring, you’ll have to pay for the privilege. Even with non-recourse, check the T&Cs as many factors refuse to assume liability under certain circumstances (further details on recourse below).
- How well do they know your industry? It’s preferable to opt for a factor which has experience in your industry. Some factoring companies specialise in specific industries, meaning they can offer tailored packages and more effective support.
- Terms: Read the terms and conditions offered by each provider, making sure you are clear on all charges and additional fees.
If you’re unsure on who to go with, it’s worth exploring using a broker to help you find the best deal. They typically have the necessary industry knowledge to spot a good deal and may be able to find a contract tailored to your specific business needs.
What do I need to apply?
Once you start submitting applications to factoring companies, they will want to review your company to determine their risk level, if they can factor the invoice/s and how much to charge you.
Invoice factoring providers will typically want to consider your credit and transaction history, view your invoices, carry out a credit check and may also ask for additional documents. Make sure that your accounting software and financial records are up to date and that you have all necessary supporting documents ready to provide.
How long does it take to get invoice factoring?
Lenders typically provide advance sums within 24 hours of receiving an invoice. In terms of setting up a factoring facility, some providers will approve your application and begin providing finance within 24 hours. Other companies can take up to two weeks to process and approve an application.
List of invoice factoring companies
With these factors in mind, it’s time to start looking for an invoice finance provider. To aid you in your research, here’s a brief overview of some of the financiers on the market.
Disclaimer: The details below were accurate at the time of publishing this article, we are not promoting or guaranteeing any particular provider or product in this list, this list is purely for informational purposes. You should always carry out your own research and seek professional advice before deciding on if to use any financing facility, product or provider.
ABN AMRO Commercial Finance
ABN AMRO offer services to large companies as well as startups. If you are a fledgling business, however, you will need to provide a solid business plan and have forecasted revenue of over £1 million in the first year. This lender is, therefore, only suitable for companies with a high potential for growth.
You can apply over the phone, after which you will need to attend a meeting. The whole process takes approximately five days. One of the benefits of this provider is that they offer a 6-month trial period with no commitment, which mitigates the risk of getting locked into a standard 24-month contract. This trial demonstrates the confidence that ABN AMRO have in their products, which is likely down to their excellent customer service, rated one of the best in the industry.
Aldermore Invoice Finance
Aldermore have one of the slower application processes, taking up to several weeks to reach a decision, making them a less viable option for companies looking for quick cash. That said, they have an exceptionally high approval rate of 90%. If you’ve previously been rejected from other finance providers, Aldermore may be an option for you. They were also awarded the Invoice Finance Provider of the Year award by Credit Today in 2015.
Close Brothers Invoice Finance
Close Brothers offer access to up to 100% of the value of invoices with their Liquidity Plus scheme. Their products aim to support larger businesses with a minimum turnover of £500,000. Close Brothers determine bespoke fee structures based on your activity, so they’re unable to provide any prices for their services until you apply. Close Brothers offer a comprehensive platform, reconciling factored payments with existing invoices, making it one of the more accessible services to use.
Hitachi Capital UK
Hitachi offer services to clients with a minimum turnover of £50,000. Their application is short and concise, requiring only an online quote and telephone call. They’re upfront and transparent with their fees, making them a popular choice – they are one of the largest factoring companies in the world, with over 800,000 customers. This experience has contributed to, and no doubt has arisen from, their excellent customer service. In 2019, they won the Business Moneyfacts Award for Best Factoring & Invoice Discounting Provider.
Metro Bank offer advance rates of up to 90% of the value of invoices. Customers must apply over the phone. Their terms are particularly friendly to SMEs, as there’s no requirement for a long-term commitment, with most contracts including a 28-day notice clause. They also don’t have any minimum fees or set-up fees.
Skipton Business Finance
Like Metro Bank, Skipton offer an advance rate of up to 90%. They don’t require clients to have a minimum turnover, making them a helpful provider for smaller businesses. They offer a high level of transparency when it comes to payment terms and fees, and can provide facilities covering your entire sales ledger, up to the value of £5 million.
Frequently asked questions
Is invoice factoring regulated?
Invoice financing and thus factoring isn’t currently regulated in the UK, nor is any asset-based lending. It’s therefore all the more important to practice due diligence when looking for an invoice factoring provider.
The FCA (Financial Conduct Authority) is responsible for regulating thousands of financial service firms in the UK. Although invoice factoring as a service isn’t regulated, it is worth checking whether your lender appears on the FCA for other services it offers. The FCA requires its members to fulfil specific standards and follow certain practice procedures. A company is likely to be more credible if the FCA approves them for other services.
What is reverse factoring?
Reverse factoring, otherwise known as supply chain factoring, is when a finance provider commits to paying a company’s invoices to its suppliers at an accelerated rate, in exchange for a discount. Reverse factoring is a funding solution used by a larger company to help the smaller companies with which it works, such as its suppliers, to finance their accounts receivables.
Reverse factoring differs from invoice factoring as the client isn’t backing their own accounts receivables, but rather those of its suppliers, in exchange for a discount. Although this incurs a cost for them, this fee is minimal if it ensures a smooth supply chain, preventing any loss of revenue from delayed manufacture.
Reverse factoring works by freeing up cash further down the line which facilitates a speedy supply chain, an effective solution for all links in the chain. This is often especially useful for companies at the end of a long supply chain. If one of the links doesn’t have the working capital that it needs to complete a job, the rest of the chain suffers. Reverse factoring provides suppliers with the cash they need to complete a task, eliminating the risk of delayed production, protecting the sales of the larger company later on.
Reverse factoring is typically used by large manufacturers and suppliers that sit at the end of a long supply chain. The suppliers benefit from faster access to working capital, and the manufacturer benefits from a timely supply chain, keeping their customers happy and sales flowing.
Final thoughts on invoice factoring
Businesses of all sizes and spanning all industries struggle when their cash flow doesn’t line up. Recent studies suggest that small businesses receive late payment for over 60% of their invoices. A delay in funds can lead to substantial financial problems even for profitable companies. Without the operating liquidity to pay suppliers and staff, business can grind to a halt.
Invoice finance can be a useful way to remedy temporary cash flow shortages by releasing capital tied up in outstanding invoices for companies to use whenever they see fit. This flexibility facilitates investment and growth for profitable, cash-poor businesses. Invoice factoring not only provides quick access to cash but frees up time and resources within your business that would otherwise go towards debt collection and sales ledger management.
Ultimately, invoice factoring can be a fast and effective solution to solve your cash flow issues. As with any finance option, factoring has its own positive and negatives. Weigh up the pros and cons for your business to find out if invoice factoring is the right solution for you.
If your still not sure quite how factoring works in practice, here’s a quick case study. A Sussex based logistics firm is looking to expand. The company is profitable but struggles to reconcile its cash in against cash out to leave any working capital left to implement its strategy for growth. Late payment is part and parcel of the logistics industry and coupled with the pressures of vehicle maintenance, fuel prices and irregular payroll commitments, maintain its cash flow has become a serious problem.
To help, the firm approaches a finance factoring company. The factor investigates the company. The logistics firm is reputable in its local area and has recently won contracts for some large national projects. One of their clients is the local council, and it also has many long-standing customers with good reputations.
Subscribe for entrepreneurial & small business advice
Subscribe to our newsletter for advice and insights on starting, managing and growing a small business in the UK.
The factor considers the company low risk in light of its creditworthy customers and sizeable invoices. The factoring company offers the company a £300,000 factoring facility. Within several months, the business sees exponential growth owing to its boost in purchasing power. The company expects to triple its turnover in the next two years, thanks to its asset-based lending providers facility.