Business owners looking to fill gaps in cash flow or improve cash flow management usually have lots of questions about invoice factoring, but one thing that’s often overlooked is an explanation of what it is. Here’s a simple explanation.
What is invoice factoring and how is it used?
Invoice factoring is a form of financing where a business owner sells invoices to a factoring company for fast access to funds. The business owner receives cash for the invoice amount, usually less fees, ahead of the payment terms. The business owner’s customer, who is responsible for paying the invoice, instead pays the invoice amount to the factoring company according to the original payment terms. Invoice factoring also goes by the terms accounts receivable factoring or receivable financing. (It’s important to note that this is different from invoice financing, where a factoring company still gives a business owner cash for their invoice, but the business owner pays back the invoice amount themselves, plus a fee. Find out how to choose between invoice factoring vs invoice financing.)
This simple definition doesn’t tell the whole story about factoring. To understand ifactoring and why many businesses use it, it’s helpful to understand what it is not. There are a lot of misconceptions about factoring that have given it a bad reputation.
It’s not a loan; business owners don’t have to worry about paying the money back because their customer pays the factoring company. Most importantly, choosing to factor invoices doesn’t mean a business is struggling or can’t reliably serve its customers. Add to this perception that many traditional factoring companies charge hidden fees, don’t fund the full invoice amount, and take weeks to pay, and you can see why some people have a bad impression of factoring.
Thankfully, the truth couldn’t be more different: invoice factoring makes businesses more successful when they need to maintain their cash flow in the face of long invoice payment terms. (In fact, it often helps business owners stress less about their cash flow situation!) Let’s get more specific.
How is invoice factoring used?
The reason there’s a demand for factoring is because of cash flow issues caused by long business to business (B2B) payment terms. In many industries, it’s not uncommon for standard payment terms to be anywhere from 30 to 120 days. Instead of business owners being paid right after they’ve delivered goods and/or services, they have to wait to receive customer payments.
This is a particularly difficult problem for small business owners who have large customers. They are excited to close a household-name customer for a large contract, but when they read the payment terms, they see that they won’t receive the money for months. This impacts their ability to remain positive cash flow, not only making it difficult to run their business, but causing them anxiety. These small business owners need that money sooner rather than later to pay expenses, which can include:
- Making payroll
- Buying new equipment
- Paying their own suppliers
- Hiring staff
- Fulfilling large orders or projects
Those last two points are more common than you might think. With improved cash flow, many small businesses find themselves able to bid on projects that will require them to buy lots of materials or labor. Companies that had to turn down business due to a lack of cash can take on the extra volume. If this sounds like a stretch, just take a look at our customer stories. Run Veggie and Global Pipeline are two companies who are particularly direct examples of growing with invoice funding.
To understand how they were able to get paid quickly, it’s helpful to understand some basic information about the process.
How does invoice factoring work?
Every factoring company, business, and their customers are different, so these steps are generalized accordingly. This is more or less what you can expect when you factor an invoice.
- Business owner submits outstanding invoices for funding. Traditional invoice factoring companies often require a business to factor all their invoices for the duration of a contract. With many newer companies, you can choose which invoices you want to fund. (Full disclosure: FundThrough lets you pick which invoices to fund.)
- Factoring company does due diligence. Oftentimes this will include checking that a business is legally established, is up-to-date on taxes, and doesn’t have liens on their accounts receivable and/or the specific invoice. (Many factoring companies will find ways to work with businesses if they have these issues.) During this step, the factoring company will also verify that the invoice is real.
- The business’ customer is asked to sign an NOA. Having the customer owing the invoice sign a Notice of Assignment means they understand that the factoring company now owns the invoice so they can redirect payment. While a lot of business owners get concerned about their customer being involved, many large companies especially are used to this process.
- The business owner gets funded. The business owner receives cash in their bank account, less a fee (or, the invoice factoring cost). They can now have peace of mind that they have cash available to grow their business or cover any other cash flow gap. (This is our favorite part!)
- The customer pays the factoring company according to the invoice terms. When the invoice is due, the customer pays the factoring company, and the process is complete.
Advantages of Factoring
Small, growing businesses see multiple benefits of factoring, especially if they don’t want to be tied up with a bank loan. Here are a few benefits they typically see:
- Debt-free funding (not a loan!)
- Non-dilutive capital
- Unlimited access to capital
- Fast turnaround
- Save time without having to chase accounts receivable
Disadvantages of Factoring
Like any financing method, factoring isn’t perfect. Here are the main perceived disadvantages of factoring invoices:
- Invoices need to be verified, so customer contact is sometimes required. (See how we work to maintain your relationships with customers if this worries you.)
- Can be complicated to account for in bookkeeping
- Some factoring companies charge hidden fees, such as a service fee or minimum volume fee
Get more info on invoice factoring advantages and disadvantages.
Why is invoice factoring useful
Invoice factoring is useful boost to your business finances for a variety of reasons:
- Making payroll. This is one of the most common reasons to factor an invoice for quick cash. Important to note is that you can factor an invoice for any expense; it’s certainly not limited to payroll.
- Funding growth. Many of our clients fund invoices so that they can pay upfront costs associated with landing a big contract or taking on more customers.
- Increasing peace of mind. So many business owners worry about their cash flow. Having a funding option like factoring that’s always available ensures that they don’t have to worry about meeting their financial obligations.
Can invoice factoring save you money?
Not exactly – but it can help you get more money in the long-term. If you have the cash to take on more business than if you’d waited for a customer to pay according to a 30, 60, or 90 day invoice payment term, you’ll grow your business and ultimately make more money. Our customer stories have many examples of how this works for all kinds of businesses.
When should your company use factoring?
Your company should use an invoice factoring solution if:
- Banks have turned you down for a business loan or line of credit, or you don’t want to be tied up in traditional bank loans or lines of credit.
- You need quick access to cash – in a few business days rather than a few months
- If you need a reliable source of cash for paying daily expenses and/or fueling growth
- You’re a startup company without much credit history yet. In many cases, invoice factoring doesn’t require a credit check or high credit score because it relies on the credit of your customers.
- You want more time to focus on your business instead of chasing down late payments.
Can any business use invoice factoring?
It depends on the requirements of the factoring company. Many require a certain length of time in business, minimum invoice volumes, or only work with particular industries. It’s important to look into these requirements to help you decide whether to use invoice factoring services or if you’re evaluating an invoice factoring agreement from a factoring firm. Be sure to also ask whether they require a service fee and about their advance rate (or the amount that’s typically paid to you up front. Some factoring companies for example will advance 80 percent of the invoice when they fund you and keep the remaining 20 percent until your customer pays. This is called the factoring reserve.) Some also require that you fund up to a certain minimum instead of letting you fund just a single invoice.
Invoice Factoring Definition and Terms
Invoice factoring definition
Also called receivable factoring, invoice factoring is a financial tool designed to provide a quick cash advance. A business owner sells invoices to a factoring company. The business owner receives cash for the invoice amount, usually less fees, ahead of the payment terms. The business owner’s customer, who is responsible for paying the invoice, instead pays the invoice amount to the factoring company according to the original payment terms.
What does factoring an invoice mean?
It means that you get cash for unpaid invoices quickly, rather than having to wait on your customer to pay according to 30, 60, or 90 day payment terms that they dictate. In other words, you can turn unpaid invoices into cash.
Are There Different Kinds of Factoring?
In addition to factoring, another related funding solution is invoice financing. This is when a factoring company still gives a business owner cash for their invoice, but the business owner pays back the invoice amount themselves, plus a fee.
Invoice Factoring Examples
If you started this article unsure about what invoice factoring is, you now have a comprehensive explanation. Beyond the dry definition, it’s important to know what it isn’t, why business owners use factoring, and how it works at a high level. A solid understanding of the whole picture and process makes you fully informed about this financial tool and how it can make a difference not only for a business itself, but in the life of the business owner.
We’ve found that when a business owner has steady cash flow, they’re freed from a huge hurdle keeping them from growth, and they no longer worry about having enough cash to keep their business running – even if they have enough money in accounts receivable. Having peace of mind about cash flow while being able to grow their business is why so many successful business owners take advantage of invoice factoring.