What is invoice factoring?
When a company uses Invoice factoring, it sells some or all of your company’s outstanding invoices to a third party. For instance, if you have 100 invoices adding up to $44,000 in Accounts receivable, you can sell the invoices rights to a 3rd party for a percentage of the value of the invoice. The 3rd party factoring company will try to collect all invoices and will get paid with thr difference between what they collect and what they bought the invoices for.
Why would you do invoice factoring?
Invoice factoring is mainly used to improve cash flow. A factoring company will pay you most of the invoiced amount immediately, then collect payment directly from your customers.
Invoice factoring is also referred to as accounts receivable factoring or debt factoring.
How does factoring work?
Invoice factoring means selling control of your Accounts Receivables either in part or in full. It works like this:
- You provide goods or services to your customers in a normal way.
- You invoice your customers for those goods or services.
- You “sell” the raised invoices to a factoring company. The factoring company pays you the bulk of the invoiced amount immediately, typically between 70% and 90%% of the value.
- Your customers pay the factoring company directly. The factoring company chases invoice payment if necessary.
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The factoring company pays you the remaining invoice amount – minus their fee – once they’ve been paid in full.
When should your company use factoring?
Your company should use invoice factoring when you routinely have a lot of invoices outstanding and do not have resources or systems to collect rapidly your AR.
Advantages of factoring
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Improved and more predictable cash flow – By using invoice factoring, you can have the bulk of your invoices paid almost immediately rather than having to wait for the money to come in (potentially after extensive chasing on your behalf). It makes business planning and forecasting more accurate and allows you to take advantage of opportunities that might otherwise be unaffordable.
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Cheaper and easier than a bank loan – Invoice factoring is usually cheaper than a bank loan.
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Reduces your business overheads – Invoice factoring services could reduce your business overheads. While there are fees associated with invoice factoring, they may be less than the cost of paying a dedicated collection team.
Disadvantages of factoring
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Unsuitable for businesses with few customers – Invoice factoring isn’t suitable for companies with only a handful of main customers. Factoring companies prefer to spread their risk as widely as possible. They try to avoid a high concentration of invoices to just a few customers.
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Requires a big commitment – Although it’s sometimes possible to factor in a small number of invoices (known as selective factoring or spot factoring), most factoring companies will want to take over the bulk of your accounts receivable. They may also try to tie you into a long contract, which could be two years or more. This is necessary from their perspective, but it means you can’t just dip in and out of invoice factoring at any time. It’s a major business decision.
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Costs more if your customers are risky – Factoring companies do their best to accurately determine the risk of late payment or non-payment of debt. This means they will assess your customers carefully. Their fees will reflect their perception of credit risk – if you or your customers are deemed high risk, fees will be high.
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Can harm your relationships with customers – When you factor invoices and the credit-control is handled by the factoring company, you are handing over some of the control over your customer relationships too. If the factoring company pursues the debt in a cold or aggressive manner, you risk your customers being put off working with you in the future.
What are the alternatives to invoice factoring?
Accounts Receivable automation is the most common and successful alternative to invoice factoring. It allows accelerating the collection of your past due invoices without paying an expensive factoring service. one collection agent can now collect hundreds of past invoices in hours.