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What Is Invoice Factoring & How Does It Work?

invoice factoringFactoring is a non-conventional method of financing that can provide businesses with a means of funding in exchange for the sale of its invoices, or accounts receivable, to a third party. This is known as a “factor.” The factor then collects payment on those invoices from the business’s customers.  Factoring helps improve the cash flow of companies that have slow paying customers.  A factoring company purchases the invoices of a company which gives the company access to immediate funds to be used for day-to-day operations. These benefits can make factoring an ideal alternative, especially for growing companies with a cash flow shortage.

Invoice Factoring – how does it work?

Typically, the factor pays an initial amount referred to as the “factoring advance”, which ranges from 70 to 85 percent of the total invoice value (sometimes in as little as 24 hours). The factor collects payments for the invoices and sends the remaining amount (30 to 15 percent), less any applicable fees to the company.

Before accepting invoices, the factor conducts their own due diligence to determine the creditworthiness of those responsible for paying the invoices, and their ability to pay their invoices on time. This is a fundamental process as the factor wants to limit their exposure to uncollectable receivables.

After accepting a company’s invoices, the factor reviews the outstanding invoices for accuracy and completeness.  Once this is complete, the factor requests payment from the company’s customer and provides them with a notice of assignment. This informs the customer of the service and instructs them to send all future payments directly to the factor.

After payment has been made, the factor transfers the residual amount on the invoices back to the company.

Factoring Fees – how much does it cost?

There are two factors that affect a company’s factoring rate or fee.  First, the factor’s risk of buying a company’s invoices and, secondly, a company’s factoring volume.  More specifically, low-risk transactions with a high volume usually qualify for lower factoring rates.  Conversely, high-risk transactions with low volumes usually receive higher factoring rates.

Factoring companies determine a company’s risk and factoring volume by reviewing monthly factored volume, amount of each invoice, the industry in which the company operates, creditworthiness of the customers, and the overall stability of the company.

While rates vary among factor companies, they generally range from 1.5 to 4.5 percent per 30 days.  More factor companies are starting to charge a management/administration fee which generally ranges been .5 and 2.5 percent. Advances, which is the amount a company receives upfront, usually range from 70 to 85 percent.

Factoring companies generally use a variable fee structure. However, some factoring companies offer a flat fee structure.

Variable Fee Structure

Under a variable fee structure, the factoring company discounts a small percentage (X to X percent) of the invoice for as long as the invoice remains unpaid.  For example, a factoring company may charge 2 percent for the first 30 days and .05 percent for every 15 days that the invoice remains unpaid.

Flat Fee Structure

Flat fee structures are less common and involve a one-time fee that is charged up front.  The fee remains the same regardless of how long it takes for the invoice to be paid.

Advance Rates

Advance rates represent the amount the factoring company is willing to pay upfront, and these vary by industry.  Industries that are riskier and harder to fund such as medical and construction can expect advance rates between 60 and 80 percent. Advances for general businesses and staffing companies can be anywhere from 80 to over 90 percent.

Another issue that affects factoring fees is whether the company chooses a recourse or non-recourse factoring program.

Invoice Factoring Companies – who provides these services?

Most major banks offer factoring services to its clientele.  The rates and terms will vary from one provider to the next and should be researched carefully.   A few of the larger banks in the UK that offer factoring include:

  • HSBC
  • Lloyds
  • Barclays
  • RBS
  • Santander
  • Standard Chartered

There are an overwhelming number of factoring companies and financial institutions that provide factoring services.  As with any competitive market, each company has their own method of doing business and how and what they charge their customers.  Be sure to do your research and obtain quotes from several companies to ensure that you understand what you are being charged. Only then can you can make an informed decision as to whether factoring is the right source of financing for your company.

Invoice Factoring or Invoice Financing – what’s best for your business?

Invoice financing is a broad term used to describe asset-based lending products that allow companies to finance slow-paying accounts receivable. While invoice factoring is one option, another option includes using a company’s receivables to secure a revolving line of credit through an asset-based loan.

The best product for your company is entirely dependent on the company size, financial strength and individual needs. Invoice factoring is able to be used by any sized company, including even small businesses who have little history. You do not need much to be able to qualify for factoring, its quick and easy as long as you have accounts receivables that are unencumbered from clients deemed to be creditworthy.

Asset-based loans, or Invoice Financing, are generally reserved for financing companies in need of a larger financial sum, commonly a minimum of around a million dollars of monthly receivables is required. Qualifying companies must demonstrate sound internal controls around the financial process, a full set of statements and assets is necessary to indicate this. When applying for an asset-based loan a company will need to perform a financial audit. Asset-based loans tend to be easier to qualify for than applying for bank credit.

 

Selecting the Right Invoice Factoring Service – what do you need to consider?

Factoring may or may not be the right fit for your business. If your company is insolvent or finds it difficult to fund daily operations due to large outstanding invoices, factoring should be an option that is explored.  Selecting a Factoring service does not have to be a complicated process.

Reputation

The reputation of a factoring company is key, and it is paramount that you do the necessary research before doing business with them.  Consider the experience of the factor, those that have been in the business for several years often have well-established funding sources and should have a streamlined process in place to ensure quick funding.

Competitive Rates
With the volume of factors and those companies that offer factoring services, it is in your best interest to comparison shop for competitive rates.  The rate a factor charges will have a significant impact on the overall cost, and it may not be in your best interest if the fees are above a certain threshold.

Good Terms

The rate should be competitive, but the terms a factor offers should also be competitive and agreeable.  Haggling out the terms may slow down the process up front, but taking the time to negotiate the terms will be well worth the effort.

Selecting an invoice factor is a decision that should not be taken lightly, and it is important to consider their reputation, overall experience, and both the rates and terms that they offer.

Qualifying for Invoice Factoring – what do you need to demonstrate?

Generally speaking, it is easy to qualify for invoice factoring.  However, there are certain qualifications that a company must demonstrate before they will be approved to factor their invoices:

  1. Creditworthiness – Although a company’s credit is taken into consideration, factor companies are more concerned with the credit of the customers that will be making payments on the invoices to be sold.
  2. Invoices that have been issued – Factoring companies will only consider invoices in which a company has a right to collect. Proposed invoices or invoices for future work will not qualify for factoring.
  3. Company reputation – A company must have a clean financial and tax background. A factoring company does not want to enter into a factoring agreement with a company that is nearing bankruptcy or has multiple tax liens.