What Is Invoice Factoring?

What is invoice factoring?

Invoice factoring is a business financing tool that offers fast funding. In contrast, choosing a business loan may be a lengthy process, and there are no guarantees you’ll qualify. Factoring also makes it easier for business owners with questionable credit to get funding because the owner’s credit isn’t really important — it’s their clients’ creditworthiness that matters.

With these advantages, invoice factoring is especially prevalent in industries that don’t lend themselves well to conventional financing solutions, such as:

• Logistics companies
• Staffing companies
• Consultants
• Attorneys

How does invoice factoring work?

Only companies that create invoices for clients are eligible for factoring. The process starts when your business performs work for a client. Once the work is complete, you invoice your client. Here’s what happens next:

1. Apply with a factoring company: If you need cash faster than the client typically pays, you’ll apply with a factoring company.
2. Identify invoices: After your business is approved to work with a factoring company, you identify the individual invoices against which you want to borrow.
3. Clients are vetted: The factoring company vets the client to ensure they have a reputable history of paying their invoices.
4. The factoring company advances funds: If the factoring company approves the invoice, you assign the invoice to the factoring company. The factoring company then advances your business a portion of the money you’re owed on the invoice (typically 80 to 90 percent).
5. You receive your money: Once you receive your advance against the invoice, you can use the money however you want — such as for expansion, equipment or payroll liabilities. The factoring company takes responsibility for collecting the invoice.
6. Your client pays the invoice: After your client pays the total invoice, the factoring company sends you any funds left after the loan is repaid, accounting for interest and other fees.

Invoicing factoring example

Consider a small staffing agency that currently fills about 25 jobs per month. This company makes a relatively small number of monthly placements because it serves small businesses that only occasionally need new employees. Everything changes when a major corporation in the local market approaches the staffing company to fill 25 positions per month for the corporation alone.

This is great news for the staffing company — it now gets to invoice the corporation for a whopping $500,000 per month. However, since its invoicing terms are net 60, it won’t get this first $500,000 payment for another two months. That’s a problem: The cost of hiring new employees for the corporation exceeds the staffing company’s cash resources. The staffing company decides to pursue invoice factoring to get money immediately to cover its costs.

The factoring company charges a 3 percent fee for its loan, or 0.03 x $500,000 = $15,000. It also agrees to let the staffing company borrow 85 percent of the invoice’s cost, or 0.85 x $500,000 = $425,000. Two months later, the corporation pays its invoice, so the factoring company pays the staffing company $500,000 – $425,000 – $15,000 = $60,000.

Ultimately, the staffing company spent only $15,000 and received the vast majority of its cash sooner rather than later.

What is the difference between invoice factoring and invoice financing?

Invoice financing and factoring are similar but have several key differences. To use invoice financing, you must apply with a lender and get approval to borrow against certain invoices. Then, you can get an advance on the amount your client owes you.

However, when you use invoice financing, your business is still responsible for collecting on the invoice. Once you do, you use the payment to repay your loan, plus interest and fees. After you’ve repaid the loan, you may be able to borrow against other invoices.

In contrast, with invoice factoring, you effectively sell your invoices to a factoring company. [Read related: Bootstrapping or Equity Funding]

Here are some additional differences between invoice financing and factoring:

• Importance of credit: In invoice financing, your business’s creditworthiness is a significant consideration. In factoring, your clients’ credit is far more important.
• Responsibility for collections: Factoring companies collect on the invoices you assign them and forward any additional proceeds to your business. With invoice financing, you collect on the invoices and use the proceeds to repay your loan.
• Reborrowing: In invoice financing, you typically must repay your loans before borrowing again. In factoring, you can typically factor any approved invoices sent to approved client companies, regardless of your business’s outstanding loans.

So, while factoring typically allows you to borrow against any outstanding invoices you’ve sent to approved clients, invoice financing has an underwriting process much more similar to conventional loan products, such as unsecured business loans.

How much does invoice factoring cost?

Invoice factoring is one of the easier types of financing for businesses to qualify for, and it allows you to get cash very quickly — much faster than most client companies pay their invoices. The downside is that factoring is one of the most expensive forms of business financing available. Here are some of the costs involved:

• Advance rates: While this isn’t a direct cost, most factoring companies will only advance you up to 80 or 90 percent of the value of your invoices. The factoring company holds the rest in reserve until your client pays the invoice, and it deducts interest and fees.
• Interest: Factoring companies’ interest rates typically range from 0.5 to 4 percent per month, much higher than conventional financing.
• Late payment fee: Factoring companies may charge you a fee if one of your clients pays their invoice after it’s due.
• Returned check fees: If one of your clients pays the factoring company but their check doesn’t clear, the factoring company may charge you a penalty.
• Wire transfer fees: Some factoring companies charge fees to process wire transfers when distributing advances to you or receiving payments from your clients.

Factoring costs can be much higher than those of other financing types. There are often ways to reduce costs, but these vary by factoring company. For example, borrowers in specific industries (such as healthcare) may receive lower interest rates than others. You may also save money if you handle payments electronically. Of course, the sooner your clients pay their invoices, the lower your fees will be.

[Looking for additional funding options? Read: How to Get a Bank Loan for Your Small Business]

Pros and cons of factoring

While factoring offers several advantages as a form of business financing, it also has drawbacks. These pros and cons make factoring ideal for some businesses in specific industries and a poor solution for others.

Pros

• Quick application process: Unlike conventional financing, invoice factoring involves more vetting of your clients than of your business.
• Shift liability: If you factor your invoices, you are no longer responsible for collecting payments — the factoring company handles that.
• Ease of borrowing again: When you factor invoices, you often don’t need to wait for previous invoices to be paid before factoring more.
• Options for bad credit: If you have bad credit and can’t get approved for other business loan solutions, you can often still factor your invoices to help grow your business or cover operating costs. [Read related: The Best Business Loans of 2024]
• Fast funding: Factoring lets you get cash as soon as the next day in some cases — much faster than waiting 30 days or more for your clients to pay.

Cons

• Narrow eligibility: Only businesses that invoice their clients can qualify for factoring.
• Client creditworthiness requirement: While business owners with bad credit typically have no difficulty financing invoices, you need creditworthy clients to factor your invoices.
• Low advance rates: Factoring companies only advance you 80 to 90 percent of the amount you invoice your client.
• High interest rates: Factoring companies charge around 1 to 4 percent per month, which works out to 15 to 35 percent APR. This is about the same as credit card interest and much higher than the interest on other types of business loans.
• Additional fees: Factoring companies often charge additional fees for wire transfers, returned checks, and late collections; they do this even though you can’t ensure timely payment from your client after assigning their invoice to a factoring company.

This last point is worth highlighting because when you factor an invoice, you effectively sell that invoice to the factoring company and give up any right to collect payment yourself. Even though you can’t ensure the invoice’s collection, the interest you pay is based on how long it takes your client to pay the invoice.

What to look for in a factoring company

Like other lenders, factoring companies come in all shapes and sizes. Each has its strengths and limitations as well as specialties. If you think invoice factoring may be a good way to help you finance your business, consider these aspects when picking a lender:

• Industry specialty: Most factoring companies specialize in one or more industries or specific business sizes. Find one that understands your industry and needs.
• Low interest rates: The interest on invoice factoring can be very high, so ensure you understand the rates your potential factoring company charges compared to its competitors.
• High advance rate: Factoring companies limit the amount they advance borrowers relative to the size of the invoice. Work with a factoring company that lets you access as much of your money as early as possible.
• Online invoice management: Good factoring companies have online platforms where you can log in to check the status of invoices you’ve factored and submit new invoices for factoring.
• Few additional fees: Ensure you won’t be blindsided by unexpected charges.
• Fast funding: Factoring companies should give you access to your cash within a day or two.
• Easy renewal process: Once you’re approved to work with a factoring company and it has approved one of your clients, factoring additional invoices should be quick and easy.

Getting the cash you need sooner rather than later

Invoice factoring is a fast, easy form of financing for qualifying businesses. While factoring involves higher interest than many other types of business financing, the right factoring company can be a great partner to give you quick access to cash for work you’ve already performed; this helps you operate and grow your company.

When you need cash you know is headed your way, but that’s not yet in your hands, lean on factoring. You’ll spend only a bit of your outstanding invoice amount to get paid sooner rather than later — and with that extra cash, the possibilities are endless.

Max Freedman contributed to this article.