Offering longer payment terms might help you secure more clients, but what happens when you can’t pay the bills because you’re sitting on a pile of outstanding invoices? Fortunately, with invoice factoring, everyone wins: Your clients don’t have to pay for goods and services immediately, and you can access the working capital you need to pay off short-term obligations. But invoice factoring isn’t a practical financing option in every scenario — you need to know when to use it, how it works, and some advantages and drawbacks.
What is invoice factoring?
Invoice factoring is a financing solution that businesses use to meet immediate cash needs. It involves “selling” (or transferring the ownership) your outstanding invoices to a third-party factoring company at a discounted rate for a cash advance.
And yet, invoice factoring is surprisingly underutilized. According to the Federal Reserve Banks’ Small Business Credit Survey, only 4% of small businesses used factoring in 2021, compared to 72% that used loans and lines of credit.
But it does have its place. This type of transaction makes sense in the B2B (business-to-business) space because clients don’t generally pay for goods as soon as they’re provided. It’s not uncommon for a business to perform a service and get paid within 30 to 90 days.
What’s the difference between invoice financing and factoring?
Both invoice factoring and invoice financing provide a cash advance based on your accounts receivables. But invoice financing is a type of loan, and invoice factoring is a financial transaction.
Factoring means you’re selling your clients’ invoices to a third-party company so that you give up ownership of that asset and that part of the relationship. In the end, factoring companies collect the money from the client, not you.
With invoice financing, you use the proof of unpaid invoices from your accounts receivable to get a cash advance. The finance company lends you the money, but your business still handles the payment collection and is responsible for paying any interest fees.
What’s the difference between factoring and collections?
Although invoice factoring companies collect invoices for businesses, they’re not collection agencies. Collection agencies focus on debt, whereas invoice factoring is a current transaction.
Factoring companies usually only take on invoices sent out in the past 30 days so that they’re still current and active. On the other hand, collection agencies are utilized for past-due invoices at least 60 days old.
When to use a factoring company
Invoice factoring can come in handy if you’re waiting for your receivables to come in and you need to meet current business expenses. Many small business owners also opt for this method because the factoring company looks at your clients’ credit scores, not your business’s.
This option is also a swift solution for small business owners hoping to bridge a cash-flow gap they didn’t expect. For example, if a customer fails to pay a hefty invoice on time, you might not have enough in your bank account to pay your upcoming monthly expenses. You can use their invoice and other customers’ invoices to give to the factoring company to generate quick cash.
How does invoice factoring work?
Invoice factoring is faster and more efficient than other types of financing, like applying for a bank loan or line of credit. Here’s how it works:
- You send the invoice to your customer for the goods or services you provided.
- You submit your invoice(s) to a factoring company.
- In exchange, they agree to give you a portion of the invoice, not the total invoice value (usually between 80% and 90%).
- The factoring company collects payment from your clients.
- If there is a remainder of the invoice value, they’ll pay you the difference minus their fee.
However, you still might be responsible for an unpaid invoice. Who’s responsible depends on the factoring you use: Recourse or non-recourse.
- With recourse factoring, you might have to buy back the invoice if the client doesn’t pay on time. You’ll usually get a lower factoring fee, also known as the invoice discounting rate, when you use recourse factoring.
- With non-recourse factoring, the factoring company deals with a late or unpaid invoice. Because this adds an extra layer of risk to the transaction, the factoring company will charge you a higher rate.
Which option works better for you is entirely subjective. Recourse factoring is a good option if you’d instead save money. But if you’d rather have the invoice out of sight and out of mind, leave it to the pros with collections using non-recourse factoring.
What’s a good factoring rate?
Generally, factoring agreements include a discount rate between 1% and 6%. However, the rate your factoring company offers will depend on a few factors:
- Invoice amount
- Sales volume
- Creditworthiness of clients
- Whether you use recourse or non-recourse factoring
If your sales volume is high enough and your clients have good enough credit, you could end up with a low rate. What’s unique about factoring is that you can get a low rate, even with poor credit.
Invoice factoring example
Your concrete company, ABC Paving, is waiting on an invoice from a partner, a building manager, for $8,000. The invoice payment terms give the client 60 days, but you need that cash to cover operating expenses until other receivables come in.
So, you turn to a factoring company that agrees to advance you 80% of the invoice’s value. You’re using recourse factoring, so you have to pay a relatively high fee. It’s 5% of the invoice value, which comes out to $400 for each month, or $800 total until the invoice is due. The company gives you 80% of the invoice amount (or $6,400).
Your client then pays the factoring company on time. Once the payment is received, the factoring company then turns around and pays you the remaining advance: $800, which is the remaining 20% of the invoice amount ($1,600) minus the $400 fee for every 30 days ($800).
In the end, you keep $7,200 of that $8,000 invoice (or 90%).
Remember that factoring companies might charge other fees, such as a new account or wire transfer. Always check the fine print before agreeing to a transaction.
Pros of factoring
The advantages of invoice factoring include:
- Access capital quickly. There’s no long-approval process so you can get cash immediately.
- Maintain good client relationships by offering more extended payment periods. This flexibility can be a unique selling point that makes your business more attractive than competitors.
- There’s no need for collateral. Don’t worry about handing over an asset in exchange for your cash advance. Factoring won’t seize anything if a client fails to pay.
Cons of factoring
The disadvantages of invoice factoring include:
- Factoring can be expensive compared to bank loans and credit cards. You may have to pay collection or overdue fees for a slow-paying client.
- Invoice factoring cost and approval are out of your control. If your clients have poor credit, you might be charged a higher interest fee or not qualify.
- The invoice factoring company collects from your client, which may affect your relationship with your client.
Optimize your accounts receivable with AR automation
The more you understand how and when money flows into your business, the better you can determine what you should use to access cash for your short-term needs.
And if you choose invoice factoring, you can use it in several ways: Pay off short-term bills, negotiate better terms with your supplier, or even incentivize clients to pay faster by offering payment discounts. However you choose to utilize this method, streamlining your accounts receivable process with automation software can also move things along.
AR automation from BILL enables you to manage your accounts receivable accounts without all the stress of tracking everyone down — in turn, making it easier for your team to focus on what’s important: Getting paid on time and having the working capital if you don’t. Learn more about how AR automation software can help your business.