What is invoice factoring and is it worth it?

Small Business Finance » What is invoice factoring and is it worth it?

In a nutshell, invoice factoring is an alternative funding option, whereby a company can sell its accounts receivables (unpaid invoices) to a third-party company. This third party assumes responsibility for collecting the invoices, whilst the business who sold them originally can benefit from the funds. It’s easy, it’s quick, and it brings in cash.

Invoice factoring continues to grow in popularity as more small businesses use it to combat late payments of invoices which blights so many sectors. The FSB’s research has found that late payments of invoices is a huge problem for SMEs and 37% of small businesses run into cash flow difficulties so it is no surprise that that over 40,000 companies used invoice finance and asset based lending in 2018. It has been a godsend for many small businesses, but — as good as it sounds — is selling invoices actually worth it for your business? Is there a catch?

How does invoice factoring work?

Why would a company be willing to buy your outstanding invoices — what is it in for them? Of course, it has to make business sense for the third-party, too. So in exchange for assuming the responsibility of chasing payments, invoice factoring companies will always charge you a fee (more on this later).

Typically, once you have come to an invoice factoring agreement with a funding provider, you’ll receive two separate payments from them. The first, initial payment is a quickly-paid, significant lump sum; this is a percentage of the total invoice value (usually around 80%). The remaining percentage comes your way once the invoices are settled and it’s here the factoring company makes their money, by imposing healthy fees on the last rebate, subject to the settlement of the invoices.

So, you might be wondering, how does a factoring company buy invoices from me? Here is a brief outline of the process:

Step 1 is to submit the invoice details to the factor company, who will determine if you are eligible. They will then determine the risk involved and provide you with a quote. Often a minimum annual turnover of £50,000 is a prerequisite, plus other criteria (mentioned below).
Step 2 is to get paid the initial lump sum (e.g. 80% of the invoice amount), providing an agreement has been made.
Step 3 is then the collection of the invoices from the factor, which will inevitably be a lengthy process, so bear that in mind.
Step 4 Once collected, the factor pays the remaining balance with a deduction of a pre-agreed fee (e.g. 20% minus fees)

What’s the difference between invoice finance and factoring?

You may have heard the term ‘invoice finance’ when researching ways to convert outstanding receivables into working capital. Essentially, invoice finance is an umbrella term, used as a catch-all for the various ways a business can borrow against unpaid invoices.

The two most commonly offered invoice finance products are invoice factoring and invoice discounting. Whilst you may see the term ‘invoice financing’ used interchangeably with factoring and discounting, these approaches are, in fact, very different.

What’s the difference between invoice factoring and discounting?

The most important difference between invoice factoring and discounting comes down to whose responsibility it is to collect the unpaid invoices.

With invoice factoring, the invoice becomes the responsibility of the third-party company.

In invoice discounting, the invoice remains your responsibility to collect – once the accounts receivable are paid, you hand back that portion of the loan (plus fees).

Both these alternative funding options raise working capital very quickly, but invoice discounting is somewhat similar to a secured loan where an asset (the invoice) is used as collateral. Usually, a company can raise around 80% of the invoice value and pay back a smaller fee than if factoring — somewhere around 1% to 3%. Yet, unlike with factoring, the company is still responsible for the collection of the outstanding receivables, so there’s a related business cost to be considered there.

In addition, finance providers will usually ask for a set fee when factoring. Whereas discounting may require more bespoke checks into the firm and a certain percentage of the total outstanding invoice(s) value to be paid. Nevertheless, discounting usually works out cheaper because you haven’t waived have the administrative duties of trying to chase up receivables.

So rather than time or money becoming the deciding factor, you may want to think about your relationship with customers. Invoice discounting will be preferable if you do not want your customers to be aware that their invoices have been factored; instead, they will continue to deal with your accounts team directly.

Why would you think about using invoice factoring?

The main reason why you may be drawn to invoice factoring is because you’re in need of cash. Cash flow is the number one reason why SMEs fail and thus quick financing is greatly valuable. Sure, there are business loans out there provided by banks they may be preferable in many scenarios, but these take time as well as a very strong credit rating. Factoring is therefore a safe source of cash flow for those with little time, or who fall short of eligibility requirements for business loans from a bank. It does come at a price, though, so companies with a low profit margin may not be able to afford factoring.

Lastly, the collection of invoices can be a real resource drain. Factoring is ideal for those who are struggling to collect, or simply are spending way too much time on the collection process. Outsourcing menial tasks to free up more time for revenue-generating tasks is usually considered a good strategy for small companies.

Pros & Cons

Pros:

Raise quick funds in a safe way.
Smooth over cash-flow issues.
Typically quicker and more accessible than a bank loan.
Transfer the responsibility and time involved in chasing up invoices.
Avoid diluting equity.
Experienced debt collectors from the factoring firm may actually improve the payment times regarding the long-term.

Cons:

It is more costly than getting a bank loan, thus it may only be suitable for those with high profit margins.
Threatens your relationship with customers, who have to now deal with an unknown third-party.
This leads to a lack of control, which exposes you to how the third-party goes about their business.
May damage chances of future borrowing or investment.

Typical invoice factoring fees

Unfortunately, it’s difficult to give even a ball-park figure for typical invoice factoring fees. There are not only a lot of considerations (volume of invoices, what market the business operates in etc.) but there’s generally a large variety of services actually being offered from the factoring companies themselves.

But, generally speaking, there are two types of fees you may be asked to pay:

Discount charges

Discount charges are the price you’re paying for borrowing the money (regarding that first ~80% advance you received) — similar to interest on a bank loan. Be aware though: it’s not just the discount rate to think about, but how the initial advance affects how much you’ll pay in fees. This discount charge will usually be around 1% to 3% over the base rate, and is calculated on a per day basis.

Service charge

Service charges reflect the cost of having to collect the invoices, as well as general admin. This is typically around 0.75% to 2.5%

Does my business qualify for invoice factoring?

As with any financial service, there will be criteria you need to fulfill. This will differ depending on the provider, but here is a rough look at the requirements you may be asked to meet:

Your business must issue a reasonable volume of invoices.
You must have more than just one customer.
You must be able to prove that receivables can be collected within a practical timeframe.
Your business must have a minimum annual revenue of £50,000 (many factoring companies ask for £100,000+, however).
And, occasionally, a minimum-maximum number of invoices per month must be met.

If you think you’re eligible, and that invoice factoring is worth it for your business, you should have a read of our article on the best invoice factoring companies.