Man sitting in armchair working on laptop | What is invoice factoring?

What is invoice factoring?

March 22, 2023
As a small business owner, managing your cash flow can be a constant challenge. One possible solution that many businesses use is invoice factoring.Not only can this improve your cash flow situation, but it can help stabilise your business finances, too.However, while it may sound the ideal approach for protecting your cash flow, it’s important to know there are both advantages and drawbacks to invoice factoring. In this post, we’ll cover these and explain in more detail how the factoring process works.

What is invoice factoring?

As a type of invoice finance, invoice factoring involves selling some or all of your company’s outstanding invoices to an invoice factoring company.This financing company will pay you most of the invoiced amount immediately before collecting the payments directly from your customers.
An invoice factoring provider provides a credit control service for a service fee in order to recover payment of unpaid invoices from your customers, who can, depending on your invoice payment terms, can take up to 120 days to pay.

Small and medium enterprises (SMEs) typically use invoice factoring companies as they can release cash from unpaid invoices quickly without having to wait for clients to pay their invoices first.Invoice factoring services will typically provide a recourse arrangement, meaning you’ll be responsible for any invoices that are not recoverable.

A step-by-step guide to invoice factoring

Also sometimes referred to as accounts receivable factoring or debt factoring, here are the steps for how invoice factoring works:
    Your business invoices your customers for goods and services you’ve providedYou ‘sell’ these invoices to a factoring company, who will check the validity of the invoicesIf valid the factoring company will pay you 80-90% of the invoice amountIf payments need to be chased, the factoring company will do this on your behalfOnce payment has been made in full, the factoring company pays you the remaining balance, minus the factoring fee
When using an invoice factoring company, payments from your customers are made into a bank account controlled by the factoring company. As a result, your customers will know you’re using invoice factoring.Some invoice factoring providers also offer recourse and non-recourse factoring, giving you the option to insure certain customers, or even your entire sales ledger, to reduce your exposure to bad debt.

Why use invoice factoring?

If your business frequently has a large number of outstanding invoices and you find your cash flow is suffering as a result, invoice factoring is a viable finance solution.Take for instance your business operates to 30-day payment terms. While most of your customers will pay within 30 days, you may find some debtors miss the deadline and require chasing.Since these payments may are an important part of your cash flow, all the time invoices are outstanding, you can’t access these funds.Invoice factoring enables you to use the cash you’re owed before your client has been, freeing up your cash flow as a result.With readily available cash on hand, you can carry on with business as usual, without having to wait for your clients to pay up. You can then go on to use it to pay back business loans, or invest in new stock.

What are the advantages of invoice factoring?

Selling all or part of control of your accounts receivable to a factoring company has a number of advantages:
    Improve your cash flow – Getting the bulk of your invoice values paid immediately will not only stabilise your cash flow, but means you can make use of working capital sooner, making financial planning and forecasting easier and more accurate.Help your business survive — Many new businesses fail due to poor cash flow and invoice factoring can be a factor in helping you keep yours healthy.An affordable short-term funding option – Invoice factoring is generally cheaper than other financing options, such as taking out a small business loan, bank loan or overdraft.Reduces business overheads – By handing over control of your accounts receivable function to an invoice factoring company, you won’t need to employ dedicated credit control staff to expedite overdue invoice payments.

Drawbacks of invoice factoring

There are also a number of disadvantages that may mean invoice factoring isn’t the best option for your business:
    Unsuitable for businesses with only a few customers – As invoice factoring companies prefer to spread their risk as widely as possible, they won’t want to take on a large volume of invoices for a small number of customers.Long-term commitment – While some invoice factoring companies can factor a small number of invoices — known as selective or spot factoring — many prefer to take over the whole of your accounts receivable. As a result, you may be asked to sign up to a long-term contract of 2+ years.Higher costs for riskier customers – Invoice factoring companies fix their fees depending on the level of perceived risk of late payment or non-payment of debt. If your business or your customers are considered high risk, you’ll likely be charged higher service fees.Additional fees for failed payments – If any of your customers fail to pay, then you may have to repay the value of the invoice to the invoice factoring company, unless you’ve paid extra for non-recourse factoring.Potential impact on customer relationships – When you use invoice factoring, your credit control function is handled by the factoring company, meaning some of your customer relationships are handed over at the same time. Not only is there a risk that your customer relationships are impacted, it may give off the impression that your business is struggling with cash flow.

Who can use invoice factoring?

As a rule of thumb, invoice factoring facilities are better suited to companies with an annual turnover of more the £50,000.Invoice factoring is also typically used by SMEs who suffer cash flow problems due to the nature of their business. For instance, industries that experience high production costs, seasonal peaks and troughs and slow-paying clients.

Invoice discounting vs invoice factoring – what’s the difference?

One alternative to invoice factoring is invoice discounting. This confidential service allows you to finance your sales ledger on an ongoing basis and release funds against unpaid invoices.

Your customers won’t know you’re using it, making it easier to preserve your relationships with them, as you’ll continue to manage your own credit control processes.Invoice discounting is another means of helping to manage your cash flow, meaning you can continue to work on your business while waiting for outstanding payments.