Invoice Factoring: Essential Guide

invoice factoring


Invoice factoring is way for businesses to raise capital and resolve immediate cashflow problems.

Invoice factoring can be ideal for businesses looking for a more flexible way to finance new opportunities, and for businesses with challenging circumstances or that do not qualify for a traditional-style loan, for example, due to poor credit or a short trading history, invoice factoring has become a popular alternative to more conventional financing options.

However, before embarking on this form of financing and securing an invoice factoring deal, it is important to understand exactly what factoring is and how this works in practice. It is also helpful to have a clear idea of the potential costs involved in the context of invoice factoring, as well as how invoice factoring differs to invoice discounting.


What is invoice factoring?

Invoice factoring is a specific type of invoice finance designed for those businesses that trade with other businesses on credit terms, where there is typically a gap between sending an invoice and when the customer returns payment. This is where invoice factoring can add value, providing a way for these types of businesses to get paid more quickly.

More specifically, invoice factoring is a form of short-term accounts receivable finance that enables a business to effectively ‘sell’ outstanding invoices to a third-party commercial finance company. The expression ‘accounts receivable’ refers to the money that a business is owed by its customers, where accounts receivable financing allows a business to recoup early payment on some or all of its outstanding invoices, in return for a factoring fee.


How does invoice factoring work?

The factoring company, also known as the factor, ‘buys’ approved invoices, making available an agreed percentage of the value of an invoice for the business to draw down, as required, with the balance to be paid when the customer pays the debt, albeit minus the factor’s fee.

The factor will also take responsibility for collecting outstanding invoice payments from customers, as well as processing those payments and managing the credit control of the business. As such, by agreeing to an invoice factoring arrangement, a business is effectively selling control of its accounts receivable, either in part or in full, to the factoring company. The factor acts as an intermediary between the business and its customers, buying an invoice at a discount and then collecting payment based on the full value of that invoice.

The invoice factoring process can be broken down as follows:

  • The business provides goods or services to its customers in the usual way
  • The business invoices its customers for those goods or services
  • The business ‘sells’ the raised invoices to a factoring company
  • The factoring company advances the business the bulk of the invoiced amount, typically up to 80-90% of the value, often within 24 hours after verifying the invoices are valid
  • The customers pays the factoring company directly, with the factoring company chasing invoice payments, if necessary, on behalf of the business
  • The factoring company releases the remaining invoice amount to the business, minus the factoring fee, once the customer has settled the invoice in full.

Once a factoring arrangement is in place, any further invoices raised as part of that arrangement can include instructions to the customer to pay the factoring company directly, although protocol for contacting the customer can be agreed beforehand with the factor.

For example, Joe Blogg’s Business is experiencing cashflow problems and agrees to a factoring facility with Anytime Finance Company based on an immediate advance of 80% of any invoice value. This means that when Joe raises an invoice worth £10,000 and uploads this online, Anytime Finance Company will advance Joe Blogg’s the sum of £8,000. Once the customer has paid Anytime Finance in full, Joe Blogg’s will be forwarded the remaining invoice value, but with Anytime Finance Company’s fee already deducted. In this example, let’s say that Joe Blogg’s Business was liable to pay £500 in fees for the use of the factoring facility, he would then receive a further sum of £1,500 once the invoice was paid.

By receiving prepayments against its sales ledger, rather than waiting several weeks or even months for a customer to pay an invoice, a business will have far faster access to most of the money due on an outstanding invoice. For a business facing financial difficulties, being able to draw funds against the money owed to it can help to fulfil purchase orders, fuel costs, payroll, taxes or any other essential costs. Equally, for those businesses experiencing rapid growth, or even looking to expand their existing operations, invoice factoring can provide the ideal working capital solution to meet their immediate financing needs.


Pros & cons of invoice factoring

In addition to providing a business with a quick and simple solution to any cashflow problems, where the finance company advances a significant proportion of an outstanding invoice upfront, before the debtor has even settled that invoice, this can provide a cost-effective financing solution for those businesses who do not otherwise qualify for more conventional forms of financing. Even though the factoring company will deduct any fees before paying the balance of any invoice, the fees for invoice factoring are typically far cheaper than the cost of, for example, a cash advance loan, which can be very expensive.

Another key benefit of factoring is the provision of credit control services. For example, if a debtor is late in paying what they owe, the finance company would contact them on behalf of the business with whom they have the factoring agreement, reminding the customer that payment is overdue. In extreme cases, where necessary, factors may even take legal action against the customer. By handling the credit control and collection aspects of a business, the time usually spent on chasing payments can be better invested in the business itself.

However, there are also various downsides to factoring arrangements, the most obvious being that any customers will be made aware that the business is using a factoring provider as a means of short-term financing. This is because of the administrative role played by the finance company in recovering an outstanding invoice, where any communications will typically take place between the customer and the factor, and payments will need to be made into a bank account controlled by the factoring company.

In some cases, where a customer becomes privy to the financial difficulties of a business, or they are forced to deal with a third party but would prefer to deal with the business directly, this has the potential to negatively impact working relationships. In some cases, the involvement of a factoring company may create such a bad impression, especially if the customer is dealt with badly, that the business may even lose that customer as a result. As such, ensuring that the factoring company offers excellent customer service, and effectively provides an extension of the business brand, is an absolute must.


How much does invoice factoring cost?

There is no standard cost for invoice factoring, where factoring fees can vary depending on the provider. There are a wide range of lenders across the UK offering factoring facilities, from high street banks and large independent providers to small local providers and niche sector specialists, where the rates and fees can vary dramatically. The overall cost to a business can also depend on things like how well that business is performing, including age and turnover, the creditworthiness and reliability of its customers, how much the business will be factoring, the percentage of any immediate advance and the invoice payment terms.

An invoice factoring fee will usually be made up of a number of different charges which the lender will build into the overall fee structure. These can include a set-up fee for the invoice factoring facility; a discount fee calculated against the balance of funds drawn; a service fee to cover the cost of things like credit checks, customer communication and recovery of late payments; as well as the cost of any additional services, such as credit protection.

When it comes to the discount fee, this works in a similar way to interest rates on a loan although, strictly speaking, factoring is not a loan, but rather a purchase of accounts receivable at a discount. In other words, the lender buys outstanding invoices for slightly less than these are worth. This is referred to as the discount rate, calculated as a percentage of the invoice value as payment for advancing the cash. This charge will usually be applied on either a weekly or monthly basis and will typically range from 0.5% to 5% based on various factors, including the overall risk profile of the business and its customers. In most cases, the lower the risk and the greater the value of invoices, the lower the factoring charges. Conversely, the higher the risk and the lower the value, the higher the charges.

Importantly, the type of agreement in place and where the risk lies for non-payment of invoices can also impact the costs involved. Most factoring companies will offer a recourse arrangement, where the business remains liable for unpaid invoices, such that any advance payment made by the finance company must be returned if a customer defaults. However, some providers also offer non-recourse factoring, where the factor absorbs any irrecoverable debt, known as bad debt protection, although this will inevitably make the factoring facility far more expensive as the lender is accepting a much higher level of risk.


How do invoice factoring and invoice discounting differ?

Like invoice factoring, invoice discounting is a form of short-term borrowing against the outstanding invoices of a business. However, even though they are both forms of invoice financing used to help improve the working capital and cashflow position of a business, there are critical differences between these two types of invoice finance.

With invoice discounting, the key difference is that the business will remain in charge of its own credit control. As such, it will maintain responsibility for managing its sales ledger and chasing payments. The debtor will also pay the business as normal, rather than remitting payment directly to the finance company. However, an invoice discounting arrangement will usually be much cheaper because of this, where the additional services provided by a factoring company generally come at a much higher cost. As the sales ledger and collection services are not included within an invoice discounting arrangement, the client is also unlikely to be aware of any relationship between the business and the invoice discounter.

Still, it can be more difficult to successfully secure a discounting facility, where this form of financing is far riskier for a lender. As such, invoice discounters will only usually lend to established businesses with both a sizeable turnover and positive net worth on their balance sheets. Some finance companies may even focus on the quality of the debtor book and the creditworthiness of the customers, or even larger turnover, to lessen the risks. Invoice discounters also only tend to work with those businesses who have a strong and established in-house credit collection process. This is because the discounter, unlike the factor, is not responsible for managing the credit control and collection processes of the business.

In invoice factoring, where the finance company has direct contact with the debtor, with overall control of recouping the debt and ensuring that customers pay on time, factoring is lower-risk from the lenders perspective. As such, acceptance for a factoring facility is virtually guaranteed because of this. This is why invoice factoring is a popular form of finance for less established businesses with a low turnover, a short trading history or any other challenging circumstances, including those businesses facing the threat of insolvency.

Overall, it is only by understanding these differences, including customer visibility and control, and the terms on which either form of financing is available to a business, if at all, that an informed decision can be made as to the most suitable short-term finance solution.


Invoice factoring FAQs

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Legal disclaimer

The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal or financial advice, nor is it a complete or authoritative statement of the law or tax rules and should not be treated as such.

Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission.

Before acting on any of the information contained herein, expert professional advice should be sought.


Invoice Factoring: Essential Guide 1
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Gill Laing is a qualified Legal Researcher & Analyst with niche specialisms in Law, Tax, Human Resources, Immigration & Employment Law.

Gill is a Multiple Business Owner and the Managing Director of Prof Services Limited - a Marketing & Content Agency for the Professional Services Sector.

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