What is Invoice Factoring, and How Does It Work?

As a business owner, you know how important it is to maintain a healthy cash flow. But customers don’t always pay their invoices on time, creating gaps in your cash flow that are difficult to overcome. This is where invoice factoring comes in – it's a financing option that can help resolve your cash flow problems. In this article, we'll explain what invoice factoring is and how it works, so you can decide if it's the right choice for your business.

What is invoice factoring?

Invoice factoring, also known as accounts receivable financing, is a financing option allowing businesses like yours to sell their outstanding invoices to a factoring company or lender. The factoring company or lender advances a percentage—typically between 70 to 90 percent—of the invoice amount to you, depending on the industry and creditworthiness of your customers. It falls on the factoring company or lender to collect the full invoice amount from the customers. Once they receive the remaining balance, the lender deducts a fee, before sending the rest of it back to you.  

How does invoice factoring work?

Application: Your business applies for invoice factoring with a factoring company or lender. The factoring company or lender assesses the creditworthiness of your business and customers.

Approval: If the factoring company or lender approves your application, they send a contract outlining the terms and conditions of the factoring agreement.

Invoice submission: The business submits outstanding invoices to the factoring company or lender.

Advance: The factoring company or lender advances a percentage of the invoice amount to your company, typically within 24 to 48 hours of receiving the invoices. 

Collection: The factoring company or lender collects the full invoice amount from your customers.

Payment: The factoring company or lender pays the remaining balance, minus a fee, to you.

What are the benefits of invoice factoring?

There are several benefits to invoice factoring, including:

Improved cash flow: Invoice factoring improves your cash flow by providing immediate access to funds you would otherwise have to wait for.

Flexible financing: Invoice factoring is a flexible financing option you can customize to fit the needs of your business. Choose which invoices to factor in and how much to factor.

No debt: Invoice factoring is not a loan, so it does not create additional debt for your business.

Improved creditworthiness: Improve your creditworthiness by factoring your invoices. That’s one way to pay your bills on time and reduce your outstanding accounts receivable.

Time-saving: Invoice factoring can save you time by eliminating the need to chase down payments from customers.

What are the drawbacks of invoice factoring?

Cost: Invoice factoring can be more expensive than other financing options, such as bank loans or lines of credit. Factoring companies or lenders typically charge a fee, which can range from 1% to 5% of the total invoice amount.

Loss of control: When you factor your invoices, you are essentially selling your accounts receivable to a third party, which means you may lose some control over your customer relationships.

Creditworthiness of customers: Invoice factoring is dependent on the creditworthiness of your customers. If your customers have poor credit, you may not be able to factor their invoices.

Perception: Some customers may view invoice factoring as a sign of financial distress, which could hurt your business's reputation.