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.
Invoice Factoring Process
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.
Confidentiality
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.
Business Eligibility and Industry Use
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. 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.
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.
Calculating Costs and Applying for a Facility
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 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.
Final Thoughts and FAQs
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.
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.
