Small businesses and entrepreneurs don’t always get paid immediately upon sending an invoice. Depending on your contract, agreement, and specific industry standards, you may not get paid for up to 90 days (or more) after completing work and submitting an invoice.
During that waiting period, you’re still responsible for fulfilling your payment obligations to others. Rent, payroll, and other business expenses continue to add up and must be paid while you’re waiting to receive payment for your invoices.
Invoice factoring helps businesses maintain cash flow before invoices come due. With invoice factoring, a business sells an invoice to a third party in exchange for the value of the invoice, minus a fee or commission.
How Does Invoice Factoring Work?
Invoice factoring involves three parties:
- The original business to which an invoice belongs (you)
- The client or customer who owes money to the business
- A factoring company, called a factor
With invoice factoring, the original business transfers the ownership, rights, and, in some cases, risks of an accounts receivable to a factor. The client or customer must then pay the factor rather than the original company that provided the goods or services.
As a trade-off for accepting the risks of an outstanding invoice, the factor earns a fee or commission paid through the value of the invoice.
In exchange, you receive an immediate upfront advance, generally equivalent to 85 percent of the invoice value, minus the cost of the fee or commission paid to the factor.
When the factor is paid in full by your client or customer, the remaining balance is transferred to your business.
An example of invoice factoring
Assume you sell an invoice with a value of $10,000 to a factoring company. Based on the payment terms you agree to, the factor sets the factoring fee at one percent, or $100, which means you will be paid $9,900 for the invoice.
Your initial advance of 85 percent, minus the one percent fee, equals $8,415. Once the factor is paid in full by your client or customer, you receive the remaining balance of $1,485, for a total of $9,900.
| Initial invoice value | $10,000 |
| Factoring fee (1%) | $100 |
| Initial advance after fee (85%) | $8,415 |
| Remaining balance (paid after invoice is paid in full) | $1,485 |
| Total amount received | $9,900 |
Is Invoice Factoring Right for Your Business?
Invoice factoring is a viable option for B2B (business-to-business) businesses that invoice for goods sold or services performed. Factoring isn’t effective for businesses that receive payment immediately from customers, such as retail stores.
If you typically expect a delay between invoicing a customer and receiving payment, invoice factoring may be right for your business.
Can Any Business Use Invoice Factoring?
Invoice factoring only makes sense for businesses that earn income via invoices. Invoice factoring mitigates the delay between sending out an initial invoice and receiving payment; factoring isn’t effective for businesses that are paid in full immediately after selling a product or performing a service.
When Should Your Company Use Factoring?
Invoice factoring is ideal for businesses with outstanding invoices that suffer from cash flow issues. In other words, if bills and other expenses are coming due before your company expects its outstanding invoices to be paid, factoring may improve your short-term cash flow so you may fulfill your debts and other financial obligations.
How Much Does Factoring Invoices Cost?
The cost of invoice factoring is determined by the creditworthiness of your clients and customers. Because the factor is taking on the risks associated with your unpaid invoices, such as late payments or nonpayments, your customers’ ability to make payments on time directly impacts the fee or commission a factor charges.
The factoring fee, or discount rate, is often between one and five percent of the invoice’s total value. Some factors may also charge an application fee.
How Does a Factoring Company Buy Invoices?
Once your business fulfills its obligations to another business (by providing products in full or completing a service), you may sell the outstanding invoice to a factoring company. In doing so, the rights to receive payment from your customer are transferred to the factoring company.
How Can a Business Apply for Invoice Factoring?
Though invoice factoring isn’t a loan, the application process is similar. Upon finding an invoice factoring company, you must submit an application for consideration. You will be required to provide supporting documentation, including information about your:
- Business
- Accounts receivable
- Clients or customers
If the factoring company deems your application acceptable, they’ll provide you with a quote before deciding how to proceed.
How Invoice Factoring can Improve Cash Flow Forecasting
For some businesses, invoice payments are unpredictable and don’t always fall on a strict schedule. This may complicate your ability to forecast income, assess your financial stability, and plan for the future.
Invoice factoring may be leveraged to reduce the unpredictability of when you get paid. And because invoice factoring differs from a loan, there’s no need to record a liability on your balance sheet. Instead, you receive the money you need when you need it, reducing potential volatility (when or if you expect to get paid) and stabilizing your cash flow.
Advantages of Invoice Factoring
Businesses and entrepreneurs that take advantage of invoice factoring benefit from:
- Easier approval than a loan: Factors don’t require collateral and don’t run credit checks on you or your business
- Immediate access to funds: Factors pay out advances almost immediately upon approval
- Smoother cash flow: Invoice factoring negates the typical waiting period between invoice submission and its due date
Disadvantages of Invoice Factoring
Despite its benefits, businesses need to consider the disadvantages of invoice factoring, too, such as:
- Cost: In addition to commissions, some factors may require application or processing fees, or assess late fees for any invoices not paid on time by your customers
- (Mostly) restricted to B2B businesses: Invoice factoring isn’t a viable option for businesses that get paid immediately upon completion of a sale or service
- Limited control: Factors may require control of payment collection for any invoices sold to them, interacting with both your financials and that of your customers
What’s the Difference Between Invoice Finance and Factoring?
Invoice financing and invoice factoring are similar, but not the same. As its name implies, invoice financing, or accounts receivable financing, is when a business borrows against unpaid invoices it is owed.
In exchange, the borrowing business pays a portion of the invoice to the lender as a fee, as well as paying back the value of what was borrowed. Invoice financing is similar to a secured loan in that the invoice serves as collateral.
What is the Difference Between Invoice Discounting and Factoring?
Invoice discounting, or confidential invoice discounting, is similar to invoice financing, with the exception that you remain in control of collecting payments from your customers. Unlike invoice factoring, your clients and customers aren’t made aware of the arrangement, avoiding a potentially awkward situation or explanation.
What is the Difference Between Recourse and Non-Recourse Factoring?
A factored invoice may be structured in either one of two ways: recourse factoring or non-recourse factoring.
With recourse factoring, you remain partly responsible for any unpaid invoices if a customer defaults on a payment, even after you’ve sold the invoice to a factoring company. In such a scenario, the burden would fall on you to chase after late or missing payments or otherwise write off the loss.
An invoice that has been factored with non-recourse factoring means the factoring company takes on the full responsibility of payment collection, even if your customer defaults. From an administrative standpoint, this is ideal for those businesses that wish to outsource payment and debt collection responsibilities.
However, because a factoring company is taking on more risk with non-recourse factoring, fees are typically higher than with recourse factoring.
What to Consider When Choosing the Best Invoice Factoring Company
Invoice factoring companies aren’t one-size-fits-all. To find the best invoice factoring company for your needs, start by shopping around to find a factoring company that:
- Is familiar with your industry
- Has experience working with businesses of a similar size as your own
- Pays out advances within the timeframe you require
- Funds the number of invoices you need to factor
- Provides your preference of recourse or non-recourse factoring
- Charges fair and reasonable fees
Once you choose a factoring company, verify its legitimacy. If everything checks out, submit an application for invoice factoring to take advantage of the unique benefits it offers you, your business, and your cash flow.
This article offers general information only, is current as of the date of publication, and is not intended as legal, financial or other professional advice. A professional advisor should be consulted regarding your specific situation. While the information presented is believed to be factual and current, its accuracy is not guaranteed and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author(s) as of the date of publication and are subject to change. No endorsement of any third parties or their advice, opinions, information, products or services is expressly given or implied by RBC Ventures Inc. or its affiliates.