How Do You Factor an Invoice? [Step-By-Step Guide]
Small businesses can face various financial challenges when it comes to cash flow management. From unexpected expenses to customers paying late or not at all, a lack of capital can cause major problems for business owners.
In fact, a recent study by J.P. Morgan Chase found that the median small business only has a cash buffer for 27 days, with nearly 1 in 4 businesses only having a 13-day reserve. To make matters worse, approvals for bank loans have been on the decline. The Federal Reserve’s 2022 Small Business Credit Survey found that bank approvals have dropped from 74% to 66% between 2019 and 2021. In Canada, the approval rating is slightly higher, but fewer businesses are applying, and it can take weeks to get a response.
There is, however, a solution to cash flow challenges: invoice factoring.
Invoice factoring, sometimes called receivable factoring, receivable financing, or invoice financing, offers a fast funding solution that can help small businesses manage their cash flow and access the funds within days of applying. Invoice factoring isn’t a loan—it’s a form of alternative financing where businesses sell their unpaid invoices to a third-party lender in exchange for immediate payment.
In this article, we’ll look at how invoice factoring can eliminate your working capital issues for B2B businesses and how it works to turn invoices into cash.
What does it mean to factor your invoices?
Factoring your invoices means selling them to a third party for a discounted rate in exchange for quick payment. This type of alternative financing allows businesses to turn outstanding invoices into immediate capital and manage their cash flow more efficiently. At the same time, the factoring company will collect the invoice amount from customers according to the payment terms, eliminating the need for businesses to wait on 30, 60, or 90 day net terms for payment or follow-up on unpaid invoices.
In short, working with a factoring firm can save time while closing your cash flow gaps.
The process for invoice factoring is far simpler than applying for traditional bank financing. Invoice factoring services often require less paperwork and accept more businesses than a bank loan. And this financing option, unlike business loans or lines of credit applications, is fast. You can get funded within days, not weeks or months.
How to Factor an Invoice
Here are the generalized steps for how you’d factor an invoice:
1. Get approved by a factoring company. After you’ve done your shopping for an invoice factoring company, you’ll have to go through the application and approval process. This process also includes approving your customer through a credit check and other risk assessments. While your business doesn’t need to have stellar credit, it’s important that the invoices are from creditworthy clients.
2. Choose invoices to get funded. This step can look different if you work with a factoring company that requires you to fund all invoices for a customer. But if you work with one that lets you pick which invoices you fund and when, sometimes called selective factoring, this is your next step. Ideally, you’ll use a factoring solution that integrates with your accounting software so you can submit invoices directly for funding.
3. Verify customer and invoices. At this point, the factoring company will send an NOA to your customer, or Notice of Assignment. This is a document asking your customer to confirm that they’ve redirected payment to the factoring company. The factoring company will also ask your customer to verify that the invoices are real and that the service or product you sold them has been delivered.
4. Get funded. After your approval process is complete and you sign an invoice factoring agreement, you’ll get your funding in your bank account minus the factoring company’s fees. The timeline can vary between companies, but you can expect payment from one day to several days – way ahead of the 30, 60, or 90 days it would take to collect from slow-paying customers.
5. Your customer pays the factoring company. Your customer pays the factoring company when the invoice is due according to their net terms. If they fail to pay by the net terms, the factoring company will handle payment collection. At FundThrough, we work with you first in the event of a late payment. When your client fulfills the invoice, the process is complete, and there’s no more obligation on your end (unless you’ve signed a long-term contract requiring you to fund all invoices for a specific customer or a minimum monthly dollar amount.)
An Example of the Invoice Factoring Process
Let’s say you’ve won a bid for a big project that will help grow your business – but you need access to cash quickly to fund the upfront costs. You know that you have $100K in accounts receivable that aren’t due for another 30 days. But you don’t have the time to wait on traditional loan applications, so you decide to factor an invoice.
Here’s how the process of invoice factoring would work:
1. Apply and get approved. You will need to create an account with an online factoring company to apply to factor invoices. In this example, you would submit essential business information and requested documents, such as your business’s Articles of Incorporation, credit history, and similar details. Unlike with other types of financing, you don’t need to have a perfect credit score to get accepted.
2. Choose invoices to get funded. Once you are approved for financing, you will be able to select the invoices you want to fund. If you are using a factoring company like FundThrough, you can integrate your Quickbooks account with the invoice factoring provider and submit eligible invoices directly from the online portal.
3. Verify customer and invoices. The factoring company will then verify the customer’s creditworthiness and the invoices’ authenticity. After your clients sign the NOA and the invoices are verified, your request will move to the next step.
4. Get funded. Once the invoices are approved for funding, the factoring provider will transfer the funds to you, minus the fees. In this example, let’s assume you have $100k in receivables, and the factoring fee (a.k.a the discount rate or invoice factoring rates) is 2.75%. After the invoice factoring cost, you would get $97,250 in cash within a few business days.
5. Your customer pays the factoring company. Since you have sold your invoice to the factoring company, it is now responsible for collecting customer payments. The company will wait on the invoice payments.
For more scenarios see our post on invoice factoring examples.
How the Factoring Process Can Vary Between Companies
The factoring process can differ between companies, since each has its own fee structure, requirements, and industry specializations. It’s important to pay attention to these details to ensure that you get the experience you want with an invoice factoring company.
- Application process. This can be manual with lots of paperwork or technology-driven. It can also come with hidden fees, like application, service, and transaction fees. The final costs of factoring can change significantly based on the fee structure, so you’ll want to work with factoring providers that are upfront about their fees. Each factoring company may also have its own requirements for documentation, and it’s important to read the eligibility requirements and factoring contract carefully.
- Invoice selection. Some factoring companies require a contract in which you agree to fund every invoice for a specific customer, or a minimum dollar amount of invoices on a monthly basis. Others let you choose the invoices you want to fund, when you want to fund. You will need to decide the type of factoring scenario that works best for your business.
- Getting funded. Different factoring companies have different advance rates, which is the amount of your invoice they give you initially. For example, some factoring companies advance 85% of the invoice and pay you 15% less once your customer pays. Others will pay 100% of your invoice upfront, minus the transaction fee, and hidden fees you need to watch out for (like an application fee, minimum volume fee, and other service fees). Different companies also have different limits on their funding, and a few offer an unlimited invoice factoring arrangement (like FundThrough).
Get Started with Invoice Factoring
At the end of the day, invoice factoring is a simple solution that helps small businesses stay afloat in tough times and overcome common challenges associated with financing operations. Business owners can use this fast funding process to leverage improved cash flow and ensure their organization runs smoothly.
But the factoring company you work with matters.
At FundThrough, we offer unlimited funding, and straightforward fees, and our technology makes it easier than ever to apply and account for factored invoices. Get started here if you’re ready to fund an invoice!