How Factoring Finance Works

What Is Factoring Finance?

Invoice factoring helps businesses solve cash flow shortfalls by providing immediate cash for their unpaid invoices. More precisely, a factoring agreement is a contract between a provider of goods and services and a financial institution known as a factoring company. In this contract, the factoring company pays the provider a percentage of the face value of an invoice amount and then assumes responsibility for collecting the outstanding invoice amount owed for goods or services by the customer.

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What is the Benefit of Using a Factoring Company?

Companies that bill other businesses for goods and services provided often wait weeks or months for the invoice to get paid. Creating better cash flow control processes can help, but it’s not always enough to overcome cash flow shortfalls, especially when unexpected events occur at the same time outstanding invoices are piling up.

Invoice factoring companies help bridge the gap by providing a short-term debt-free working capital solution by leveraging accounts receivables.

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Factoring vs. a Traditional Bank Loan

Invoice factoring is different from a traditional business loan in lots of ways.

Is Accounts Receivable Financing the Same as Factoring?

Most people don’t differentiate between accounts receivable financing and factoring. Invoice discounting, invoice financing or receivable factoring often get lumped into the same group too.

However, the word “financing” references taking out a loan. Therefore, in true accounts receivable financing, you’re borrowing money and using your invoices as collateral. You’re responsible for collecting from your customers and you’ll pay back your loan with interest in installments. Because you retain the balance sheet, it’s like any other type of loan—your customers will have no way of knowing you’re leveraging it unless you tell them.

When the term includes the word “factoring,” you’re not borrowing money or taking out a loan. You’re essentially selling your invoices to factoring providers at a discount rate. The factoring company is responsible for collecting from your customers, and you have no debt to pay back. Customers are therefore aware when you’re working with a factoring company, but because it’s quite common and factoring companies often make it easier to pay, it’s usually seen as a positive thing.

Is Accounts Receivable Financing or Factoring Considered Debt?

Factoring is a debt-free solution because your customers are the ones who pay the balance, not you. However, a true financing arrangement does involve debt, so it’s important to confirm the terms before signing.

The Role of Payment Terms in Factoring

Payment terms, such as net 30 payment terms, play a crucial role in determining a business’s cash flow and financial stability. For businesses waiting weeks or months to receive payments, invoice factoring offers a powerful solution to bridge cash flow gaps. By selling invoices with net 30 or similar terms, companies can access immediate funding without waiting for customers to fulfill payment deadlines. This allows businesses to maintain smooth operations, cover expenses, and invest in growth opportunities without the delays typically associated with extended payment terms.

Invoice Factoring vs. Invoice Discounting

Invoice discounting is similar to factoring, but the biggest difference is in who collects. Again, with factoring, your factoring company collects from your customers. With discounting, you’re responsible for getting the payments collected, but your customers make their payments into an account that’s managed by your discounting company.

Types of Factoring

Just as there are several ways to use your outstanding invoices to solve cash flow problems, there are several types of invoice factoring too.

Which is the best type of factoring for you?

Recourse & non-recourse factoring

The checks a factoring company performs on your customers prior to accepting an invoice for payment go a long way to ensuring the customer will make good on their obligation. Unfortunately, there is no way to guarantee a company will pay their invoice. With recourse factoring, you are ultimately responsible for paying the factoring company back any amount advanced to you if your customer doesn’t pay. With non-recourse factoring, you don’t have an obligation to pay the remaining balance if the customer doesn’t pay.

Spot factoring

One of the major benefits of factoring is that a business can choose which invoices to factor and how often to factor. Some businesses factor frequently, while others do so intermittently as needed. When both parties come together for a single financial transaction—to factor only one invoice—it’s referred to as spot factoring. This is more common when a small-business owner has most or all their revenue tied up in a single large invoice and requires immediate cash to continue operating.

Reverse factoring (supply chain finance)

Whereas traditional factoring is initiated by the “seller” (the provider of goods or services), reverse factoring, also known as supply chain financing, is initiated by the “buyer” (company ordering goods or services). In these cases, the buyer is typically a large enterprise in good financial standing that wants to wait to pay an invoice, but the seller is a midsize or small business that can’t afford to wait for payment.

Picture a chain auto repair shop in the United States that needs to order a special part for an exotic car, and it’s only available from one overseas supplier. The repair shop doesn’t want to pay for the part until their customer pays for the work. Or, imagine a large retailer that’s setting up a pop-up shop and needs to pay a trucking company to move their displays across the country. The retailer may not want to pay the trucking company until their shop is generating revenue.

In situations like these, the buyer can approach a reverse factoring company and get approval for supply chain financing. However, like traditional factoring, it’s the seller that’s responsible for paying the fee. Most are happy to do so because the amount is largely based on the enterprise’s credit history, so rates are quite low, and accepting the terms allows them to fulfill a large order without waiting for payment. This in mind, both the buyer and seller must agree to the terms set. When the service is complete, or goods are transferred, the factoring company pays the seller. The buyer then pays the factoring company at a later date according to the terms set.

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What is the Factoring Process?

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What Kind of Companies or Industries Use Factoring?

Virtually any B2B company that sends invoices for services or goods after they’ve been delivered can work with factoring companies. A few of the most common industries are outlined below.

What Fees Are Involved When Using Invoice Factoring Services?

It’s important to clarify that when you’re leveraging invoice factoring services, the advance rates will vary from one company to the next and even within the same company depending on the riskiness of the deal. For example, you may only get 50 percent of a spot factoring transaction upfront. Lots of companies promote advances of 70 percent under ordinary circumstances too. On the other hand, Viva Capital will advance up to 100 percent of the value. In all cases, however, there’s usually a factoring fee involved as well.

That’s because, unlike loans, which come with interest payments, factoring companies typically charge a flat rate for their services. The amount generally ranges from one to five percent of the advance rate. The creditworthiness of your customers, your invoice volume, the level of risk, and specific terms of your factoring agreement will all weigh into the rate you’re quoted.

Suffice it to say, invoice factoring services are generally not less expensive than bank loans, but they do help businesses that don’t qualify for bank loans and are one of the few no-debt working capital solutions available for small-business owners.