What is Invoice Factoring?
Invoice factoring is an alternative method for companies to fund their cash flow. Unlike overdrafts, loans and credit cards, factoring is where businesses sell their invoices to a third party at a lower price.
How Does Factoring Work?
Factoring is when businesses sell control of their accounts receivable, which can be either in full or in part. Factoring works as follows:
- A business provides goods or services to its customers.
- As usual, the business invoices their customer for the goods or services provided.
- The business then sells this raised invoice to a factoring company.
- The factoring company will pay the business for the bulk of the invoiced amount straight away. This will be usually 80-90% of the value.
- Customers will then pay the factoring company directly.
- Finally, the factoring company pays the remaining amount, taking away their fees once they have received full payment.
What Industries Use Factoring Companies?
All different types of businesses use factoring companies. There are a few industries that factoring companies specialise in. Below are just some of the many industries that work with factoring companies:
- Oil and gas.
- Wholesale.
- Distribution.
- Consulting.
- Manufacturing.
- Food and beverage.
When Should Your Business Use Factoring?
If your business has a lot of outstanding invoices and you’re seeing your cash flow suffer, then it may be a good idea to research factoring. GoCardless give a great overview all about factoring.
During a 30-day period, you may have customers that require chasing up for payments, with some going over the 30-day limit for payment. Invoice factoring will give a large percentage of the funds immediately, while you can use the new money to do some of the following:
- Bridge short-term expenses.
- Concentrate on your business.
- Pay off debts.
- Repay any outstanding loans.
- Paying staff.
What Are The Advantages and Disadvantages Of Factoring?
Like any business decision, there are both advantages and disadvantages. For a big decision such as factoring, it is recommended to weigh up the pros and cons before committing.
| Advantages | Disadvantages |
| Create a better chance for the survival of your business. With an improved cash flow, you’re more likely to survive. Many businesses fail due to poor cash flow. | It is a commitment. Many factoring companies will try to negotiate a long 2+ years contract with businesses. They’ll also look to take over the majority of your accounts receivable. |
| Cheaper than usual bank loans and financing. For companies looking at factoring, you could see a huge saving in comparison to bank loans. | There may be added costs. Factoring companies will accurately determine if your customers are risky, if so, fees will be higher. Also, if your customer fails to pay, you may see extra disbursements. |
| Easier than bank loans. Factoring removes the hassle of obtaining funds and relieves the stress of debt management. Factoring is usually easier than finding an acceptable loan from a bank. | Harder for businesses with few customers. Invoice factoring companies will usually prefer to manage their risk as much as possible, avoiding lots of invoices to a smaller range of customers. |
| Decreases business overheads. There are fees with factoring, however, they may be cheaper than paying credit control staff and are a lot less stressful which improves staff morale. | Must factor in relationships with customers. When using factoring companies, they may use aggressive debt collection methods, which may harm the relationship between your business and the customer. |
What Are Standard Invoice Factoring Rates?
First of all, it is worth noting that there are two things to consider. That is flat rates and variable fees. StartUps.com take a deep dive into factoring costs on their site.
Factoring companies will usually calculate their rates with a variable fee method. For variable fees, a small percentage is discounted, usually, 1-3 per cent of the invoice, only if the invoice goes unpaid. The longer it takes for the customer to pay, the more fees the business will have to pay. An example could be a factoring company charging 1% for the first month, then an extra 0.25% for every 5 days the customer does not pay the invoice.
You will find that some factoring companies use a flat fee method, which is a one-off fee that will be paid upfront. So, no matter how long the customer takes the pay the invoice, the fee stays the same. Both flat rates and variable fees have their benefits and disadvantages, but that is specific to different circumstances and industries.
How Do Factoring Companies Make Money?
For businesses that factor their invoices, the factoring company will advance an amount to the business. This can be up to 90% of the invoice value. Once the factoring company has collected full payment from the customer, the remaining 10% will be returned to the business, with any fees being taken away on top of that. The fee is where the factoring companies will make their money. The way fees are calculated will depend on numerous factors.
How Do Factoring Companies Calculate Fees?
As stated on factorfinders.com it is ‘important that business owners fully understand the cost of factoring’. Factoring companies will usually charge a 1-5% fee, however, this is dependent on the following factors:
The amount of money that is being factored.
In the business world, we see the economies of scale being used, this is no different for factoring companies. So, the more a factoring company utilises their line, you’ll see further reductions in their rates.
The risk and credit quality of the business’ customers.
The business’ customers will be the ones that eventually pay the invoices that they are factoring. With this in mind, factoring companies want to make sure that the customers of the business will be able to make the payment. They don’t want the risk of not receiving the funds. Customers that have better credit ratings will reduce factoring fees, with worse credit ratings resulting in higher fees.
The length of the invoice terms and agreement.
For invoices that have a longer payment term, usually 2-3 months, factoring companies will charge a higher rate. This may seem strange, but factoring companies are advancing funds to the business for a longer period of time and as we know, time adds value.
Other factors include:
- The volume of monthly receivables you would like to factor.
- The industry that you’re in.
- The amount of time that your customers take to pay the factoring company.
How Do You Choose A Factoring Company?
As with most industries, different companies offer various benefits to compete in the market. It is the same with factoring companies, with different firms specialising in specific areas. As PRN Funding state on their website, there are literally ‘thousands of factoring firms to choose from, so it is extremely important to know what to look for’.
It can be difficult to decide which factoring company to work with, so it is beneficial to ask these questions to yourself to start:
1. Are they a reputable company and have they been in the business for a reasonable amount of time?
2. How much are their fees, as well as the funding limits and terms?
3. How quickly will you receive funding and payments for the invoices?
4. What is their process for interaction with customers and may it be detrimental to customer relationships?
5. Where does the factoring company get their funds from?
What Is Factoring Also Known As?
Factoring can also be known as:
- Invoice finance.
- Debt factoring.
- Asset-based lending.
Are Factoring Companies The Same As Traditional Lenders?
They are alike in that they are both ways of improving cash flow, however, there are differences too. Factoring is the purchase of invoices from a business, not a loan. So, businesses will not incur any debt, which you may see with loans. Also, factoring will not impact credit scores, not including the initial credit check.
Do Banks Offer Factoring?
Banks won’t typically offer true accounts receivable factoring as they will not buy invoices. Banks may use them as collateral if you apply for a loan.
Can You Have More Than One Factoring Company?
It is a law that you can only have one factoring company at a time. It is against the law to have more than one factor as it becomes tricky when deciding which factoring company owns the rights to a business’s invoices.
Once an agreement with a factoring company is made, they will then file a Uniform Commercial Code (UCC) which gives them the first right to the invoices. Once the UCC has been filed, the factoring company are allowed to take invoices. This means that even if adding a second factoring company was allowed, they could not take any invoices.
Are Invoice Factoring Fees And Interest Tax Deductible?
A tricky question, but the overriding answer would be yes, factoring fees are tax-deductible. This is given the provided funds are only used for businesses purposes and not individual use. Factoring companies could then class factoring fees and interest as a business expense. However, it is highly recommended to speak to a professional, qualified accountant to give you a concrete answer that is dependent on personal circumstances.
What is the average cost of Invoice Factoring?
The typical range of a factoring company’s discount or factor rates is 1.5% to 5%. Generally speaking, your discount rate will be smaller the more expensive invoices you “give over.”
There is no set fee for invoice factoring. The amount you are charged will always be based on how well your company is doing and how trustworthy your customers are.
The entire cost of factoring will typically depend on two factors: the discount/factor rate and the length of the factoring term (although some companies provide a flat charge structure).
On the other hand, the length of the factoring period will depend on how much time you allow your clients to pay and if they do so. Of course, it will cost you extra if the invoice factoring firm needs to wait 40 days for payment rather than only 30.
Other expenses that might be incurred, such service fees and collection fees, could potentially raise the final cost.
How Many UK Businesses Use Factoring?
According to ABFA, there are more than 45,000 businesses currently using factoring in the UK.