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What Is Invoice Factoring & How Does It Work?

July 26, 2018 Annabelle Amery

Reading Time: 5 minutes(Last Updated On: February 6, 2019)

Complete Guide to Invoice Factoring

Invoice factoring is a common business financing solution that can be a lifesaver for small-medium businesses when faced with cash-flow problems. Invoice factoring is a form of financing that converts any outstanding invoices due (within 90 days) into cash that will be immediately available for your business.

Invoice factoring is ideal for SMBs who:

Don’t want to provide collateral
Cannot qualify for large bank loans
Have cash flow issues

Invoice factoring for small businesses is a preferred financing method as credit checks can be bypassed and small businesses don’t need to present a business plan allowing them to get funded much more easily.

If you aren’t sure if this is the type of loan you are seeking, head over to our guide to business lending to see if this is the right option for your business.

What is invoice factoring?

Although gaining wide popularity in recent years, invoice factoring can be dated back to the ancient Mesopotamians some 4,000 years ago and was favored by the Romans. Merchants spread across the large global Roman Empire were able to conduct business in faraway places using factoring. Factoring made it possible for merchants to fund expeditions and continue business during the slow seasons – very similar to how its benefits today.

So how does invoice factoring work? It may sound like a fancy schmancy concept but it’s not too difficult to get your head around… in essence, factoring is a form of invoice financing where businesses sell their accounts receivable book to an external finance provider to make your life easier. You can get cash ‘now’ for all of your invoices due, and wave goodbye to late payments. Your company can then use that cash to cover expenses that need taking care of.

An external ‘factor’ will purchase invoices from a business allowing it to receive cash up front rather than waiting around for customers to pay.

How does invoice factoring work?

If you’re wondering ‘what is invoice finance factoring’ you’re not alone. The terms financing and factoring are all too easy to muddle-up. Though similar, they are not the same things and there are some key differences. Here’s an easy break down so you can see how both processes look.

A step-by-step guide to invoice factoring

Send an invoice copy to your customer that you’re factoring
Assign invoices to a chosen factor
The factor will advance ~80% of the invoice (in cash) to you immediately
Your customer will then pay (in full) the factor when the invoice is due
The factor will then forward the remaining ~20% (minus fees) in cash

A step-by-step guide to invoice financing

Create an account with a lender and sync accounting software
Select all the invoices you want to clear
The lender will advance 100% of the selected invoices
You will then repay the lender over the next 12 or 24 weeks

Be aware that some industries are more used to invoice factoring than others. For example, in shipping/trucking companies and recruiting agencies it’s common practice to use invoice factoring. If factoring isn’t so common in your industry, it may be better for you to go with invoice financing (which does not require you to assign an invoice when the factor advances it).

What are the costs?

How much does invoice factoring cost? It’s common practice that you’ll get an advance of around 80% of your invoice and then the remaining 20% after the invoice has been paid minus, of course, the invoice factoring rates which can vary from 1-4%. Some lenders will actually provide 100% of the advance rather than splitting it up and allow you to pay back the fees over the next 3-12 months.

The fee structure, however, will vary greatly depending on the factoring company you choose to go with and a number of other factors including:

Volume of monthly receivables
Average size of invoices
Industry
Length of time it takes customers to pay
Creditworthiness of your customers
Business credit score

It’s worth mentioning that the creditworthiness of your customers is one of the most important factors. The better behaved your customers (as in, the faster they pay) can mean for better agreement terms. Think about it this way, the factoring company will be taking on the financial risk of any unpaid invoices, so they need to know their risks beforehand.

When it comes to uncollected debt from your customer, each factoring company will handle this scenario differently though the general path would see them taken to court to fight the case. Be sure to read the terms and conditions of each company as it will be outlined there or in your contract.

Why use invoice factoring?

Why? Why use invoice factoring over taking out a regular business loan? The biggest plus to using invoice factoring is that it allows your business to stabilize its cash flow by removing payment delays from the equation. With a regulated stream of funds, you will be able to run and expand your business with more peace of mind. Invoice factoring is not a static loan offering a one-time payout, it’s a continuous agreement between two businesses (you and the factor) whereby both can benefit.

What are the pros and cons of invoice factoring?

Pros	Cons
Immediate cash available – to help solve cash flow issues, allowing you to pay expenses and move your business forward	Costs (1-4%)
Relatively easy to qualify compared to other loan product	One dimensional it focuses on solving cash flow shortfalls due to slow paying clients, and not much else
Only uses your invoices as collateral there’s no need to give up equity, inventory, real estate etc.	Depends on the creditworthiness of your clients if they often have trouble paying bills, you may be offered a smaller cash advance or pull out altogether
The line can increase as you need it (as long as your invoices increase and the credit quality of your clients remains good)	Factors will contact your clients (to inform them that they will manage your invoices as well as if payments are late)
Allows you to provide payment terms to clients	Still a chance invoices won’t get paid finance companies are not collection agencies (bad debt should be assigned to an attorney or collections company)

Who qualifies for invoice factoring?

Since invoice factoring is an extremely efficient way of increasing cash flow, businesses of all shapes and sizes including start-ups to large corporations use it as a cash flow tool. Meaning, any business in any industry can qualify for invoice factoring. In fact, when it comes to qualifying, it’s much, much easier than a traditional bank loan.

You can qualify for invoice factoring:

Even if you have bad credit
Not been in business long (at least 6 months)
You are making at least 6k (USD) a month
Already used unsecured loans and lines of credit
Only if you are using an online accounting software (e.g. QuickBooks and Xero)

How to apply for invoice factoring?

For those who can’t qualify for alternative funding and need to better manage their cash flow, invoice factoring for small businesses is perfect, the question remains how do you apply for it? When you apply for invoice factoring via Become, you’ll only need to fill out one application which will lead you to be shown relevant offers outlining the factors and lenders that you can qualify for. Rather than applying through many companies to see if you qualify, Become works to cut your work and make the application process much easier.

What an application process will look like:

Fill out a short application via Become’s Invoice factoring application
Select the factor, or funder that you would like to go with
You’ll receive an email where you’ll need to connect your accounting software used by your business
Read over the T&C’s and you’re ready to get started!

Disclaimer: The information contained in this article is provided for informational purposes only, should not be construed as legal advice on any subject matter and should not be relied upon as such. The author accepts no responsibility for any consequences whatsoever arising from the use of such information.