Invoice factoring is a form of transactional finance whereby a business sells its invoices for delivered products or services to a factoring company in order to close the cash flow gap. Many businesses do not have additional working capital to finance their customers, but the conventions of their industry nevertheless demand that they offer credit terms to customers.

An invoice factoring service allows your business to monetize current, unpaid invoices into a line of credit that helps you meet expenses, pay suppliers, and cover payroll.“Invoice factoring” is not a common term. Many business owners have never heard of it. However, you may have heard a variety of other terms including “Accounts Receivable Financing,” “Receivable Loans,” and “Receivable Financing.”

To summarize, a factoring company realizes invoices on credit terms as a business asset that can be used as collateral. Regardless of the term used, at the end of the day a business can get funding that is based on the value of its performing accounts receivable by a bank or a factoring company.

A factoring company specializes in financing only accounts receivable and has personnel with experience who can immediately evaluate the value of the accounts receivables being pledged. This is very important because we will talk later about how to select a factoring company.
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Who is involved in the invoice factoring transaction?

If you’re generating invoices and offering credit terms to customers for products or services delivered, then you can pledge each individual invoice or all invoices to the factoring company (Factor) for funding. Factoring agreements will vary, but they will describe what invoices will be pledged, as well as how many accounts will be pledged for factoring. The factor will set expectations for each Account Debtor’s (the customer being invoiced) level of funding.

As the company submits invoices to a factor for funding the factor reviews each invoice and ultimately either funds or declines each specific invoice depending upon the agreed-upon parameters. It is typical for funding to occur within 24 hours of submission.Each invoice is treated as an individual transaction of its own, and the fees are calculated as such. The factoring agreement is usually a seller/buyer agreement wherein the seller (Company or Supplier) is the “Client” who sells its invoices at a discount to the factor (the Buyer). With today’s technology and real-time electronic reporting, the process is simple, efficient, and perceived as a line of credit based on the invoices being generated. Some business owners feel this type of financial solution is like selling all customers on “Cash on Delivery” instead of offering credit terms.
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Typical “Factoring Terms” or “Factoring Parameters” are described in the factoring agreement. Here are some examples of terms used in invoice factoring.

A factoring company uses variable risk ratios and the cost of the administrative burden to determine the fees that it will charge a company/supplier (Client). A factor has typical overhead costs in personnel that will be responsible for servicing the Client. It also incurs other expenses during the relationship, including Credit Analysis Reporting, Tax Monitoring, Online Software Support and Cost of Funds.The factor proposes terms to the client based on the evaluation of its performing accounts, credit quality of the account debtors, invoice average amount, average of days outstanding per invoice, industry, dilution rates, and concentration ratios. A typical fee can average from 0.5% to 5%, and an advance rate from 70% to 97%, depending on the parameters mentioned above.

Factoring companies can customize the fees. Some are flat rates, and others are tiered out by the number of days outstanding. Some factoring companies charge a one-time fee and an interest rate on the outstanding balance. Others charge a tier; for example, 0.5% per 10 days until the invoice is paid with 0% interest. The average cost of invoice factoring in the current market can go as low as 0.5% to 5% depending on the number of days the invoice remains outstanding, sales volume, invoice size, and industry.

To keep it simple to understand, a factoring discount fee is about the same rate as a Merchant Credit Card Processing fee. If your business accepts credit cards, then you will notice fees on your statement averaging anywhere from 1.5% to 4% depending on the card-holder and the credit card that was used. If your business can afford to accept credit cards, then it can afford invoice factoring.

Many businesses can double sales every other month by offering credit terms and adding new accounts. Imagine selling on credit terms but getting paid like cash-on-delivery for approximately 3% of the invoice amount!

In contrast, ask yourself how much it costs to turn away business. If your business averages a net profit of 10% and you turn away business due to a lack of working capital, then you just lost 10% of your profits instead of the 3% factoring fee. Not to mention you lose a host of other benefits, such as taking advantage of any early payment discounts offered by your own vendors, and the ability to extend credit to good quality customers.

So here’s the real question. Does invoice factoring cost money, or does it make money?

If you’re going to increase sales and expand your business but are limited in your ability to self-finance your accounts receivable, then invoice factoring should make money. If you cannot afford to sustain customers on credit terms, eventually it will cost you money, or you will lose your business.

‍Learn more on how much does it cost to factor invoices?

Qualifying for an accounts receivable financing program is simple. Most companies that sell on credit terms will be approved. However, there are some basic qualification parameters that you should be aware of:
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