What Is Invoice Factoring?

Both invoice factoring and invoice discounting function as suitable strategies for businesses that need to meet pressing cash needs. Read on to learn about the pros and cons of each approach as well as how to get started.

The Basics Behind Invoice Factoring

Many businesses extend credit to their customers for services rendered. This extension of credit creates accounts receivable on the books of the business. While accounts receivable and unpaid invoices present as an asset on the balance sheet, they also increase the working capital requirements of the small business. 

Also see: What is working capital financing?

As a result of these new accounts receivable, the business experiences a reduction in operating cash flow even while it recognizes revenue. This cash shortfall can create uncomfortable situations for business owners, since employees, landlords, and suppliers do not often like to extend IOUs. 

For businesses that have experienced this working capital problem, invoice factoring can offer a solution. Invoice factoring works something like this:

• A business begins to accumulate unpaid invoices and accounts receivable on its books as a result of selling goods or services. For the purposes of this example, assume the total amount of unpaid invoices equals $1000.
• As the end of the month approaches, this business must make payroll as well as pay important bills such as rent and utility expenses. However, the $1000 in unpaid invoices makes this impossible. 
• The business does not have access to a revolver through a bank nor strong enough credit to take out a short-term loan from the local credit union. The manager of the business then turns to another solution: invoice factoring. 
• An invoice factoring company approaches the distressed business and offers the following deal: We’ll purchase your unpaid invoices in exchange for a 10% fee. 
• The business makes the deal and collects $900 of invoice value from the factoring firm ($1000 less a factoring fee of $100) and uses the proceeds to pay its end-of-month expenses.

In a nutshell, this example demonstrates how the invoice factoring process works. A business needs cash and exchanges its unpaid invoice amount for immediate funds. 

How Do Factoring Providers Bill for Their Services?

The above example demonstrated how an invoice factoring firm makes money. For a fee, the invoice factoring company will then purchase the invoices and attempt to collect the money due by itself. 

This fee, also known as a “discount rate,” usually does not exceed a single-digit percentage. The exact amount of the fee depends on the ease by which the invoice factoring company may collect the funds from the customers associated with the unpaid invoices, as well as whether or not the factoring takes the form of recourse or nonrecourse. 

Recourse invoice factoring indicates that the business must pay the invoice factoring company any invoice amounts which it cannot collect itself. The business may make these payments with cash or through other unpaid invoices equal to or greater than the uncollectible invoice in question. 

For businesses that opt for recourse invoice factoring services, the discount rate (fee) should trend toward the lower end of the spectrum, reflecting the lower risk the invoice factoring company takes in making such a deal.

Non-recourse invoice factoring, on the other hand, shifts the risk of invoice collection to the funding company. In this scenario, the invoice factoring firm will accept the entirety of the risk associated with collecting the unpaid invoices in exchange for a higher discount rate. Oftentimes, an invoice factoring company will only offer such a service if it determines that it has a high likelihood of collecting the invoices. 

If a business opts for non-recourse factoring, then it will typically pay a higher discount rate to reflect the additional risk that the invoice factoring firm takes on in this arrangement.

Related: What is asset financing?

The Differences between Invoice Factoring and Invoice Discounting

In some cases, a business may not wish to sell its unpaid invoices to an invoice factoring company. In that scenario, another invoice financing option may make sense: invoice discounting.

The invoice discounting approach differs from invoice factoring in that the business will instead use its unpaid invoices as a source of collateral for a loan. The process typically follows these simplified steps:

• The business previously described recognizes that it must make cash payments but lacks the cash to do so since it remains “locked up” in unpaid invoices. 
• Rather than sell the invoices to an invoice factoring company and lose control over the relationship with its customers, the business instead chooses to acquire short-term financing by making use of its accounts receivable as a collateral source.
• The invoice discounting finance company extends a lump sum payment to the business in exchange for invoice discounting fees based on a spread between the prime interest rate and the financing company’s desired interest rate. 
• As the business collects cash from its customers and converts the accounts receivable into actual balance sheet cash, it then repays the loan with interest. 

The main differences between these two approaches include:

• The business loses control over the collection process when it sells the invoices to a factoring company.
• With invoice discounting, the business retains control over the customer relationship but must make higher-than-average interest payments.
• Customers will not know that a business makes use of invoice discounting, but will know if the business hands over unpaid invoices to a third party. 

Determining If Your Business Should Make Use of Factoring

The choice to enlist the services of an invoice factoring company depends on the need for cash. For businesses with a strong need for immediate cash to stave off bankruptcy or lawsuits, a factoring service makes sense. While an expensive form of financing, factoring can help businesses temporarily fix working capital problems.

A small-business owner should consider several variables when making this decision, including factoring rates, the length of time to make use of this service, and the different fee structures for factoring and discounting. 

Other Types of Factoring Strategies

A variety of factoring products exist, including options for software-as-a-service companies in which the factoring company packages recurring monthly payments into one lump sum for a fee, advances on unpaid commissions for sales organizations, and many more strategies. 

The Cons of Factoring

The main challenge associated with invoice factoring or discounting stems from the high fees and interest rates associated with the service. Businesses should instead seek to fix the underlying working capital challenges associated with the problem. While invoice factoring services offer fast cash, smart business owners consider the need for these services carefully. 

Factoring Next Steps

Businesses looking to meet urgent cash needs should consider both invoice factoring and discounting based on their desire to maintain the customer relationship in-house as well as any other associated factors including interest rates and ability to repay obligations. 

While many factoring companies exist, business owners should pay careful attention to the underlying terms of the factoring agreement and any public reviews for the factoring business. Additionally, business owners should examine any public filings as well as licensing.