Invoice Factoring: Everything You Need to Know
Table of contents
Invoice factoring is a way for businesses to unlock money tied up in their accounts receivable. By selling outstanding invoices, you could get access to cash before your customers settle payment.
To help you evaluate whether invoice factoring is a good idea for your business, this article explains what invoice factoring is, how it works, types and costs of invoice factoring, as well as its pros and cons.
What is invoice factoring?
Invoice factoring is a way for businesses to get a quick cash injection by selling invoices at a discount. Typically, invoices are sold to third party companies specialized in invoice factoring services, each of which is called a “factor” or “factoring company”.
Upon buying your invoice, the factoring company will give you, in cash, a portion of the amount you are owed on the invoice. The factoring company will then collect money from your customers when the invoice is due.
In this way, invoice factoring helps you get cash quickly by eliminating the need to wait for your customers to pay.
Is invoice factoring a loan?
Invoice factoring is not a loan. Rather, it is an arrangement in which you sell outstanding invoices and the factoring company buys your invoices at a discount.
What is the difference between invoice factoring and invoice financing?
Invoice financing refers to the use of invoices to provide capital to businesses. Invoice factoring is a sub-category of invoice financing.
Learn more: Invoice Financing: Everything You Need To Know
How does invoice factoring work? (With example)
In invoice factoring, the factoring company makes two payments to you at different times. Below is a quick guide on how invoice factoring works.
When an invoice is sold, you immediately receive an initial cash advance from the factoring company.
The factoring company collects payment from your customers when the invoice falls due.
After your client has paid on the invoice, the factoring company gives you the remainder of what it agrees to pay you.
To illustrate how invoice factoring works monetarily, an example of invoice factoring is explained below.
Invoice factoring example
Let’s say you have an outstanding invoice worth $15,000, which you decide to sell to a factoring company. The factor rate is 4% and initial advance is 85% of invoice value after fee.
To put words into numbers, below is a table summarizing the above-stated factoring arrangement:
In this example, the invoice to be sold has a face value of $15,000. The cost of capital is equal to the factor fee, which is $15,000 x 4% = $600.
Thus, the invoice value after fee is $15,000 − 600 = $14,400. In other words, you will receive a total of $14,400 on this invoice.
As an initial advance, the factoring company will give you $14,400 x 85% = $12,240 of cash upfront. The remaining amount, which is $14,400 − 12,240 = $2,160, will be given to you only after your client settles the invoice.
Types of invoice factoring
There are two types of invoice factoring: recourse factoring and non-recourse factoring.
1. Recourse factoring
In recourse factoring, you are required to buy back an invoice if your customer fails to make payment on it. Some factoring companies also allow you to replace the unpaid invoice with another receivable of equal or greater value.
As an invoice seller may need to purchase back the invoice, factoring companies want to make sure that your company is in a good liquidity position and able to buy back.
To this end, you may need to provide personal guarantee to repay the amount of invoice in the event of customer non-payment.
2. Non-recourse factoring
Non-recourse factoring refers to an arrangement in which the factoring company buys an invoice without recourse to the seller. If the factoring agreement is a non-recourse one, you are not obliged to buy back or replace the non-performing invoice.
As the cost of customer default is absorbed by the factoring company in this case, non-recourse factoring is less common and usually comes with higher fees.
Recourse factoring vs. non-recourse factoring
Recourse and non-recourse factoring are two types of invoice factoring with a number of differences.
The following table summarizes their differences to help you compare these two types of invoice factoring:
Costs of invoice factoring
1. Credit check fee
To assess the risks of non-payment, factoring companies would make credit checks on your customers before approving your application. You may be asked to cover the costs of credit checks.
2. Origination fee
Origination fee, otherwise known as draw fee, is a flat rate fee charged at a percentage of each factored invoice. It is a fee for processing your factoring application and opening an account for your business.
3. Factor fee
Factor fee is calculated at a factor rate of the face value of factored invoices.
The factor rate, which is also known as factoring rate, discounting rate or discount rate, usually ranges from 1% to 5%. The amount deducted from your invoice value is a factor fee.
4. Service fee
There may also be service fees during the time the factoring company works with you.
5. Collection fee
Factoring companies may charge a collection fee for tracking down your customers to pay on the factored invoices.
6. Monthly minimum volume fee
Just like banks require you to deposit a certain amount of money in your savings account, factoring companies usually require you to factor invoices of a minimum gross volume over a given period of time. Failure to do so may lead to a monthly minimum volume fee.
7. Overdue fee
If your customers do not pay on invoices past due, you may be charged an overdue fee.
8. Termination fee
Some factoring agreements require that you work with the factoring company for a specific period of time. If the agreement is terminated before then, a termination fee will be incurred.
Pros and cons of invoice factoring
Advantages of invoice factoring
1. Relatively low threshold
Traditional financing options, such as bank lending, have stringent requirements to pass. In order to apply for bank loans, a strong credit history and collateral are essential.
Invoice factoring, on the other hand, does not require businesses to provide expensive collateral or to have stellar credit histories themselves.
Nevertheless, you may have to provide personal guarantee in a recourse factoring arrangement. Your clients should also be creditworthy in order to pass credit checks.
2. Relatively quick access to cash
If your business is structured with a long delay between sales and payment, factoring your invoices is one way to get your hands on cash quickly.
This way, you could free up the money tied in receivables to invest in your company’s growth and operations.
3. Outsource payment collection
Factoring companies take on the administrative work of collecting payment from your customers, lessening your employees’ workload so that your company’s manpower can be re-allocated to other value generating activities.
An added benefit is that factoring companies will be the ‘bad guy’ who tracks down non-paying customers. You will not have to worry about harmed customer relationships resulting from payment issues.
4. Bad debt protection
In non-recourse factoring, the factoring company assumes the risks of customer default. For this reason, some see non-recourse factoring as a kind of ‘bad debt protection’ for businesses.
Nevertheless, the terms of a non-recourse agreement must be reviewed carefully. For instance, the factoring agreement may stipulate that the arrangement is non-recourse only if your customer becomes insolvent.
Non-recourse factoring may also be limited to customers with good credit histories, so that a non-recourse arrangement is not always available to you.
Disadvantages of invoice factoring
1. Miscellaneous fees add up to a high cost
Invoice factoring comes with many fees, such as origination fee, factor fee, collection fee, but to name a few.
Even though each of these fees may not sound like much, they could add up to a very high cost, increasing the cost of capital and undermining your profits from sales.
2. Minimum volume commitment
Many businesses use invoice factoring for a quick cash injection to smooth out cash flow issues. However, there may be a minimum volume requirement that you must factor invoices of a certain gross amount within a given period.
This locks you into a commitment where you must factor and pay for the services even when you do not need them later on (or you could pay a termination fee to bring an end to the arrangement).
3. Your customers will know about the arrangement
With an invoice factoring arrangement in place, the factoring company will notify your customers of it. Your clients will also be contacted by the factoring company to make payment. There is no way to conceal the fact that you have factored your invoices.
While there are many reasons for businesses to use invoice factoring, some customers may attribute your actions to cash flow issues within your business.
To prevent creating a negative impression on customers, some businesses avoid factoring their invoices unless it is really necessary.
4. May harm your relationship with customers
Some businesses do not feel comfortable having strangers contact their customers for payment. Customer relationships may also be harmed if you used to handle clients in a personal and unique way.
5. Application could be time-consuming
Invoice factoring is a form of trade finance, the application of which requires a lot of paperwork and back-and-forth communication with the factoring company.
Before applying for invoice factoring, it would be advisable to consider whether the cash advance obtained is worth the time invested in administrative procedures.
When should you use invoice factoring?
Invoice factoring is one way to convert your receivables into cash, but it is not available to every company.
To help you determine whether invoice factoring is a good idea for your business, this section covers some characteristics of a business which could use invoice factoring.
1. You are looking for a solution to tackle temporary cash flow gaps
Invoice factoring solves a very specific problem — you need cash for your business, but 60 to 90 days is too long of a wait period.
By enabling access to cash earlier than the invoice due dates, invoice factoring is helpful for businesses that need a quick injection of cash.
2. You sell to customers on credit
You must sell to customers on credit so that you have outstanding invoices to factor.
3. You have a creditworthy clientele
Factoring companies would look at your customers’ creditworthiness as one of the considerations to determine whether your factoring application should be approved.
If there are issues with your clients’ credit histories, invoice factoring may not be easily accessible by your business.
4. Your profit margins are sufficient to cover the costs of invoice factoring
Invoice factoring is an expensive way to get a cash injection for your company. Factor rates reduce your profit from sales, and other fees contribute to the cost of capital too.
Thus, factoring your invoice to get immediate cash could lead to unprofitable sales if your business does not have a high profit margin to begin with.
Is invoice factoring right for your business?
For many small businesses, the most favourable feature of working with factoring companies is their ability to provide cash quickly.
However, invoice factoring comes with various drawbacks — high costs, minimum volume commitment, as well as potentially negative customer perception.
It is therefore important to consider whether the drawbacks are a worthy tradeoff for the speed of funding.
Alternative to invoice factoring: Revenue-based financing
At Choco Up, we offer revenue-based financing (RBF) to fast-growing companies with flexible repayment.
In revenue-based financing, RBF funding is advanced in a lump sum. Upon providing growth capital to you, Chooc Up would share a small percentage of your monthly revenue until the principal plus a flat fee is repaid.
With an aim to help businesses ‘grow now, pay later’, Choco Up is dedicated to providing growth capital which is quick, flexible and inexpensive. Below is how we achieve these goals with revenue-based financing.
1. Application is quick and easy
Choco Up understands your need for quick and accessible funding. In answer to your needs, we have built a data integration platform on which you could apply for funding easily.
To begin, you simply have to fill out an online application form and connect your sales accounts (e.g. Google Analytics, PayPal, etc.) on our platform.
Instead of compiling historical financial statements or customer invoices manually, Choco Up’s tech platform reduces tedious paperwork to just a few clicks.
2. Quick turnaround time
We also strive to reduce the wait time so that you can quickly deploy resources to fuel your company’s growth.
Without complex application or vetting procedures, Choco Up could give you access to funding in as little as 48 hours.
3. Flexible repayment
Choco Up adopts a revenue-sharing model so that you do not have to make regular repayments in fixed sum.
As Choco Up only shares a small portion of your monthly revenue as repayment, you will pay back more when you earn more, pay back less when you earn less in a particular month.
Unlike loans, there is no obligation to make a certain amount of repayment by a certain date. With revenue-based financing, you never have to worry about the situation where debt commitments drag your company down and hinder growth.
4. Simple fee structure
Choco Up only gets a small flat fee for providing RBF funding to you.
You will not be charged interests on unpaid amounts, nor will you find hidden fees in financing agreements.
If you happen to be a founder, your company’s equity is something you would want to protect. As a founder-friendly growth partner, Choco Up does not take any equity, options or warrants from your company.
6. Recurring funding available
Factoring companies may lock you into minimum volume commitments, but Choco Up leaves the decision in your hands.
While there is no commitment to obtain a certain amount of RBF funding, you could get various rounds of RBF funding as you see fit.
For example, eBuyNow, a global consumer electronics company, received two tranches of RBF funding from Choco Up over a three-month period.
With RBF funding from Choco Up, eBuyNow was able to minimize the risks of delayed receivables, invest in inventory purchase and improved its cash position by 125%.
Learn more: How did eBuyNow 5X their revenue growth?
Invoice factoring vs. revenue-based financing
Compared with traditional lending options, invoice factoring and revenue-based financing both give you quick access to cash.
To help you decide which of these two financing options is better for your business, below is a table for your reference:
Some last words
When it comes to business funding, three considerations are crucial — speed, cost and flexibility. While invoice factoring arguably checks the box of speed, it may not be best in terms of cost and flexibility.
As an alternative to invoice factoring, revenue-based financing is a quick, inexpensive and flexible solution for fast-growing businesses.
To learn more about what we do, check out our client success stories or apply for funding today.
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