The Ultimate Guide to Invoice Factoring

4 weeks ago
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If you’re a freelancer or small business owner, it’s likely that you’ve experienced problems with cashflow at some stage during your career. If you’re currently experiencing these issues it’s important to know that you’re not alone, and that there are many ways you go about tackling this problem. One of which ways is by using Invoice Factoring. 

What is Invoice Factoring? 

Invoice Factoring is a type of Invoice Finance that allows you to improve the cash flow within your business. This method differs from a business loan, as it produces an increase in cash using the money that’s already owed to you by your clients or customers.

A recent study conducted by the financial software company Intuit revealed that 69% of small business owners have been kept up at night due to worry about their cash flow problems. Issues surrounding cash flow are extremely prevalent within small businesses, with a report from U.S. Bank revealing that the main reason why small businesses fail is because of poor cash flow management. 

How does Invoice Factoring work? 

The process of using an Invoice Factoring company to improve your cash flow is simple. 

Firstly you sell your outstanding invoices to the factoring company in exchange for a lump sum. This often totals 70-90% of the invoice value. You will then have access to this money straight away, without having to wait for payment from your customer or client. 

Once the payment terms are up (usually after 30 days) and your customer has paid what they owe, the Invoice Factoring company will pay this money back to you, minus any fees they charge for their service. If your customer hasn’t paid what they owe in time, the invoice factoring company will chase up the payment on your behalf. 

Example of Using an Invoice Factoring Company 

Tom owns a small business and has been experiencing problems with cash flow over the past few months. He’s decided to make an agreement with an Invoice Factoring company with an agreed advanced percentage of 90% and a fee of £500. 

Tom issues an invoice to a customer totalling £10,000 on 30 day terms. Usually, Tom would have to wait for the customer’s payment before receiving the money. However, his agreement with the Invoice Factoring company means that they will give Tom £9,000 in advances (90% of the invoice total). This allows Tom to access the money straight away. 

The customer will then pay the factoring company what they owe Tom (£10,000). And the factoring company will then give Tom the remaining payment, minus their £500 fees. This means that Tom will be left with £9,500 of the original invoiced amount. 

If the customer does not pay what they owe within the 30 day terms, the Invoice Factoring company will chase payment. If the customer has been reminded and still fails to pay, the Factoring company may take legal action. 

Recourse & non-recourse facilities 

There are two different types of invoice factoring facilities; recourse facilities and non-recourse facilities. Choosing between the two depends on the relationship you have with your customers and how likely you think they are to pay invoices on time. 

What’s the difference between a recourse and non-recourse facility? 

If your customer does not pay an invoice even after they’ve been prompted, the payment will still have to come from somewhere. With a non-recourse facility the factoring company absorbs the cost, meaning that you won’t miss out on a penny. 

However with a recourse facility, you would have to absorb the cost of any unpaid invoices, which is likely to cause even more problems with cash flow. For this reason, non-recourse facilities are often more expensive than recourse facilities, as the risk of the lender having to absorb costs is much greater.  

It’s important to think carefully about which type of facility you choose, taking into account your customers’ payment history and whether or not you think they’ll pay reliably. 

Discount rates and service fees

A frequently asked question surrounding Invoice Factoring is ‘How much do factoring companies charge?’. This varies hugely from company to company and is based on a range of factors including the type of facility (recourse or non-recourse) mentioned above. 

However, the two main components of invoice factoring prices are discount rates and service charges. 

What is a discount rate? 

Discount charges are similar to interest rates in that they’re based on a percentage of the total cost of an invoice (typically between 0.5% and 5%). This charge tends to be applied on either a weekly or monthly basis and is typically lower when releasing invoices of high value. 

The discount rate you receive is based on an array of factors, including creditworthiness of your customers, how complex the service needs to be and the overall risk involved. 

What is a service fee? 

Service fees are important to bear in mind for small businesses, as they’re often much higher for smaller companies than for larger organisations. This is an ongoing service charge that’s based on your company’s turnover. The higher your turnover is, the less you’re likely to be charged. 

Finding the right factoring company 

Finding an invoice factoring company (also known as a ‘factor’) that suits your specific circumstances can be tricky, as there is a huge range to choose from. The most important things to consider when choosing a factoring company are; 

Cost – Make sure you look into prices and are aware of how much they can differ if your company’s profitability changes. Also look at service fees and discount rates. 

Reputability – Does the company have good (and legitimate) reviews? Are they regulated by a trade body such as the ABFA?

Flexibility – Are there any strings attached or can you leave the facility if you’re dissatisfied? Does the company offer any flexibility if you need it? And if so, how do you go about getting this?

High street banks and challenger banks 

Many high street banks offer factoring services, however they can be picky about the businesses they want to work with. If you’ve already got an account with a bank that offers invoice factoring then you’ll be much more likely to be offered their services. Banks are well regulated and fees are generally low, making this option great for small businesses and freelancers. 

Alternatively, many challenger banks are now offering factoring services to SMEs. These usually come with rather competitive fees and are often considerably less fussy about the companies they offer their services to. 

Independent facilities 

Major independent Invoice Factoring companies are ideal for those who have customers with unreliable payment histories. Their wealth of knowledge and experience enables them to find ways of making deals work that other lenders may struggle with. 

Local providers

Smaller independent providers can also be a great choice for small and micro businesses. They can provide a tailored service to suit your company’s individual needs and find ways to help improve your cash flow using Invoice Factoring. 

Sector specific facilities  

There’s also a range of facilities who operate in specific fields. They tend to have much more industry-specific knowledge and experience than other providers, allowing them to advise you in the best way possible. 

Pros and Cons of Using a Factoring Company 

As with other types of Invoice Financing, there are a wide range of benefits and drawbacks of using factoring companies. 

Pros 

What are the advantages of Invoice Factoring for a small business? 

Instant access to cash 

Using a Factoring company instantly increases your cash flow, enabling you to have access to finances you’d usually have to wait for. It’s also much quicker than other alternatives such as business grants, which can often take months to be approved. 

Time saving 

Having someone else deal with your invoicing will free up a lot of your time. Particularly if it means you don’t have to worry about chasing customers up every month if they don’t pay on time. This will allow you to use your time to focus on other parts of your business that you may have otherwise missed. 

Easy to access 

Unlike loan providers, Invoice Factoring companies do not need to assess you based on your credit score and loan history. Instead, they focus primarily on your customer or clients’ payment history as they’re the ones who’ll be paying the Factoring company back. 

No collateral risk 

Unlike with other types of loans, there is no requirement to submit collateral when it comes to invoice factoring. The only collateral involved are the invoices themselves. 

Better relationship with customer 

Having help from a factoring company can improve the way your customers perceive you. If you’re not the one chasing them up for payment, this can help to ‘shift the blame’ almost, and in turn may improve your relationship. 

Cons 

What disadvantages are there of using a factoring company? 

Fees 

No matter which type of company you choose to go with, you’ll still need to pay for the service. This means that when using an Invoice Factoring facility, you’ll never receive 100% payment of an invoice. 

Financial responsibility  

Even though many companies will chase up unpaid invoices for you, there’s only so much they can do. If the invoice remains unpaid after a reasonable amount of time and you’re with a recourse facility (explained above), it will be your responsibility to absorb the cost. 

Access is determined by your customers

If your customers have a ‘bad’ payment history and the lender thinks they will not pay on time, they can refuse to work with you. It doesn’t matter how good your credit or loan history is, you may still be rejected if the lender feels they can’t rely on the customer to keep up their payments.  

Trust 

You have to put your faith in the Invoice Factoring company you’re working with, as they’ll be the ones handling your invoices. This often makes people feel a little nervous at first, however if you’ve done your research and you know you’re working with a reputable facility you should have nothing to worry about. 

We hope this article has provided you with a good understanding of what Invoice Factoring companies are, how they work and the pros and cons of using them. 

If you’re not sure about using a Factoring company or would like to find out more about other options available to small businesses, head over to our Business Funding Options page.

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