What is invoice factoring?
Invoice factoring is an invoice finance facility that businesses use when they sell their outstanding invoices to a factoring company at a discounted rate. They get an advance on the money they’re owed whilst the lender takes over the credit collection process.
Invoice factoring, which is also referred to as debt factoring, is a specific type of invoice financing. This form of financing provides companies with instant cash injections in exchange for a service fee.
You receive up to 100% of your invoice value almost instantly, whilst the factoring company takes over the hassle of chasing your payments. Once your debtor pays the outstanding amount, the lender releases all remaining payments.
It avoids late payments and cash flow gaps – two influential factors to the survival of any business.
How does it work?
Invoice factoring works by selling your outstanding invoices to a factoring company, typically in exchange for a predetermined financing fee.
This fee is calculated as a percentage of your company’s gross turnover. One fee will usually cover all collection, administration, and management costs associated with the financing.
After processing your invoice and deducting the service charge, up to 100% of your invoice value is advanced and the lender proceeds to take over the payment collection process.
For example, if you’ve agreed on a 1% factoring fee and you issue your client an invoice for £10,000, the lender can advance you £9,900 as soon as your invoice is cleared.
This way you can benefit from the highest amount of capital in the shortest amount of time. You can then use this cash to pay contractors, pay your employees, or complete projects.
How does debt factoring improve cash flow?
Debt factoring can improve cash flow by advancing you a majority of your invoice value in a matter of days instead of weeks. You won’t have to sit around waiting for your clients to pay you, instead you can get on with other vital aspects of running a business.
A majority of small businesses in the UK have less than three months of cash reserves to sustain themselves. If you’re forced to wait months for several outstanding invoices, the survival of your business could be in jeopardy.
When you seek out financial assistance from banks, in the form of a loan or overdraft, it could take months before this is approved. Even if the bank does finally approve your financing, the funds could take a few weeks to materialise.
Invoice financing offers smaller businesses and startups the opportunity to receive financing whilst also offering enterprises of all sizes an excellent method to cover short-term cash flow problems.
Non-recourse vs recourse factoring
Within invoice factoring, there are two types of debt factoring, known as recourse and non-recourse factoring.
Non-recourse and recourse factoring refers to the process employed by the factoring company when a debtor abstains from paying their outstanding invoice.
Recourse factoring is the most common way to deal with a client that doesn’t pay their invoice. In this instance, you take full responsibility for the unpaid invoice and repay the cash that was advanced to you. This is more common because it is the least expensive way to deal with non-compliant clients.
A non-recourse agreement is when the factoring company assumes all of the risks. Although the lender assumes full responsibility, they also take on more risk and, therefore, non-recourse factoring fees are substantially higher.
Some factoring companies will only agree to non-recourse factoring and take responsibility for the unpaid invoice if a customer has declared bankruptcy.
The factoring fees between non-recourse and recourse factoring can often vary by as much as 1%. Therefore, it’s worth debating which is the right option for your business.
However, factoring companies have a team of dedicated professionals who will try to collect payments as quickly and efficiently as possible. A capable credit team won’t be willing to work with clients that have unfavourable payment histories.
What is reverse factoring?
Reverse factoring is when large corporations use financial institutions to bankroll their purchases in a quick and reliable way.
This method of financing, also known as supply chain finance, helps improve cash flow and reduce supply chain risk by helping buyers pay their suppliers quickly.
In brief terms, the factoring company acts as an intermediary and agrees to finance the buyer’s purchase in exchange for a fee.
This quick cash payment provided by the financing company helps buyers negotiate a discount and also helps suppliers accelerate their cash flow.
However, reverse factoring is only an option for large and established corporations with reputable trading histories.
Factoring and forfaiting
Invoice factoring refers to the sale of outstanding invoices to a debt factoring company at a discount for an immediate cash advance.
Forfaiting is when an exporter sells its claim of trade receivables to a foreifetar for an immediate cash payment.
Forfaiting is a form of export financing that is only used for international trade. Time frames for forfaiting can last several months or even years, making it substantially lengthier than factoring.
What are the costs of factoring?
Factoring costs can vary per company, however, they are typically calculated as a percentage of your gross turnover.
Some debt factoring companies will charge you a single fee that encompasses all costs associated with the factoring service.
However, other invoice factoring companies may try to add hidden charges, like startup fees, exit fees, or credit check fees. Therefore, it’s always important to read the fine print before entering an agreement with a debt factoring company.
How do all-in-one invoice and back-office solutions work?
Invoice factoring with back-office support services allows businesses to work with financiers in a disclosed manner.
The invoice factoring company will collect payments on behalf of your business, using your company name, your logo, and your VAT numbers.
This service also comes with back-office functions that help support and manage the running of your different contractors.