What is Invoice Factoring and How Does it Work?

What is Invoice Factoring and How Does it Work?

Factoring involves a process where a factor agent buys your outstanding invoices, otherwise known as ‘accounts receivable’. They then pay you an advance of up to 90% of what those invoices are worth, and repay the remainder of the outstanding invoice amount when your clients pay those invoices (minus a commission fee and any interest on the advance).

This is an ideal way to improve cash flow and generate working capital to ensure you have enough money in the business to pay bills and creditors. So if you need some cash fast, and are willing to pay a commission on your outstanding invoices (anything from 0.5-4.5%), factoring could be a solution to your cash flow problems.

How much advance a factor provides you with depends on the credibility of the company you’ve invoiced, so they will pay a greater percentage should you have outstanding invoices from the likes of Microsoft than if you have outstanding invoices with a selection of sole traders or smaller businesses.

Once you have taken on a factoring agent to factor for you, they will take on responsibility for the debts and administer your sales ledger. They’ll distribute statements and reminders to your clients retaining goodwill with those customers. Bad debts may be passed back to you, but only with a type of factoring known as ‘recourse factoring’.

Get a reference or two from previous clients of the factoring company you select.

How Does Factoring Work?

You choose a factoring firm, agree the contract, remembering to check the company’s references before signing anything.

Inform your customers you are using a factoring company by attaching a sticker to your invoices that states that the factoring company has been legally assigned to manage your sales ledger debts and distributing them to your customers for work or sales completed.

Send copies of all of those outstanding invoices to the factoring company each week or at agreed intervals of an agreed number or agreed total invoice value amount).

Receive a percentage of the value of those invoices from the factor (up to 90%) which is paid by return on receipt of your invoices or at an agreed time/at agreed intervals.

Get on with the important stuff, as the factor agent will run your sales ledger, distribute statements, chase and collect payments.

Receive the balance of the total invoice value minus the agreed commission fee you pay the factoring company (including interest on the advance funds). This will happen as soon as your customer pays the factoring company.

The Pros And Cons of Factoring as a Cash Flow Solution

The Pros

  • Factoring shortens the sales cycle. (The period from buying your stock or materials from suppliers too receiving payment from your customer). So, your income is enabled to grow in line with sales.
  • Factoring gives you more time to focus on managing, growing and building your business, as the agent will take over the time-consuming adminstration of your customer accounts and manage all of this on your behalf. The company ensures you have access to the cash whenever you need it.
  • Factoring can be a worthy method of financing fast growth and seizing opportunities. You may find an overdraft is not enough to fund rapid growth, and factoring can free up funds that are locked in unpaid sales invoices to finance such growth.
  • Factoring gives you the bulk of the money fast. Some factoring companies will be able to provide you with the agreed percentage of the total outstanding invoice amount within 24 hours of you issuing those invoices.
  • Factoring is flexible based on your current and future forecasts, trading and needs, rather than looking back at historical balance sheets and profit and loss ratios to secure finance, as is the traditional method.
  • Factoring, as long as you can afford it, enables you to plan ahead with confidence. You know how much you will have at any given time, as you know the total invoice value, the percentage of outstanding invoices paid by the factoring company and fees of the factoring company to deduct from the balance.
  • Factoring gives you the opportunity to take advantage of bulk buying from suppliers (which can save money long-term if that stock is going to sell) or discounts for prompt-payers that some suppliers may offer.

The Cons

  • Using a factor to manage your accounts used to have a stigma attached to it, as it indicated that a busines might be having cash flow problems. However, nowadays, the majority of companies have cash flow issues and factoring is perceived now as a viable way to manage cash flow effectively. If you don’t want your customers to know you are using a factoring company, try invoice discounting instead.
  • Cost. Minimum contract terms and commission fees can add up to create a relatively expensive financing tool. Sometimes contracts can be set at a minimum of three years, so you must check out such details.
    Work out how cost effective factoring will be by adding up the size of the annual minimum fee, how long the contract is commiting you for, and making sure you read the small print on the contractual agreement. Read the notice periods carefully and consider the implications before commiting to anything.

Invoice Discounting

Invoice discounting is much like factoring, except you collect payments of the invoices from your customers rather than the factoring company collecting payments.

Invoice discounting costs less than factoring because of this. After all, with factoring the company will run your sales ledger (saving you time and money of this process, especially if you employ sales ledger/credit control staff, but notifying customers of the fact you are borrowing against your debts). With invoice discounting you will retain control of your sales ledger, and therefore keep that fact confidential from your customers, but incur the time and cost of administering your sales ledger (ie. issuing statements, chasing and collecting payments).

With invoice discounting you need a turnover of £250,000 and may have to be a Limited Company rather than a Sole Trader. Factoring will often only require your business to be turning over £50,000 a year.

As you collect the monies with invoice-discounting, you will have to pay the money collected payments (that are owed to the invoice-discounting company) into a special trust account at your bank and notify the discounting company. They will pay you the balance minus their agreed fees and interest charges once the outstanding invoices have been paid into this account.

Work out how cost effective factoring will be by adding up the size of the annual minimum fee, how long the contract is commiting you for, and making sure you read the small print on the contractual agreement. Read the notice periods carefully and consider the implications before commiting to anything.