What Is Invoice Factoring & How Does It Work?

Published on March 12, 2024
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When you review your books, they may seem favorable, with assets outweighing liabilities, suggesting ample working capital. However, appearances can sometimes be deceiving — particularly if most of your assets consist of unpaid invoices.

It’s possible to have plenty of working capital but not enough cash in hand. This imbalance can harm the health and reputation of your business. Invoice factoring is a strategy that can help convert outstanding debts into liquid assets.

What is invoice factoring?

Invoice factoring is when a company sells its unpaid invoices to a third party, known as an invoice factoring company or factor, to improve cash flow and revenue stability. A factoring company will provide an up-front payment to the company selling (typically 80-90%) and then pursue collection from the customers who owe the money. Once the invoice is paid, the factor gives the rest of the remaining funds to the original company minus an agreed-upon processing fee. 

Recourse factoring vs. non-recourse factoring

With invoice factoring, there is always the risk of non-payment, but the type of invoice factoring determines which party is responsible for nonpayment. 

  • Recourse factoring is where the company selling its debt must refund any payments made by the factor. 
  • Non-recourse factoring is where the factor assumes the bulk of the risk and does not require a rebate from the company if no funds are collected. (This type of invoice factoring typically comes with higher fees.)

Invoice factoring vs. invoice financing

With invoice financing, the company doesn’t hand over collection responsibilities to an outside party. Instead, the company uses its pool of outstanding invoices as collateral, borrowing a percentage of their value from an outside bank or other financier. Using this method, the company selling is always obligated to pay back the borrowed value, even if they never collect it on the invoice.

How does invoice factoring work?

You’ll first need to establish a contract with an invoice factoring company. Still, once that’s handled, the process is rather straightforward:

  1. Your company delivers a product or service to one of your customers, generating an invoice requesting payment for the delivery.
  2. You then forward that invoice to the factor.
  3. The factoring company sends you an immediate payment equal to an established percentage of the invoice.
  4. Your company funds your working capital to fund ongoing operations.
  5. Meanwhile, the factor oversees traditional dunning methods until the customer renders full payment.
  6. Once the customer pays, the factor will hand over funds equal to the remainder of the original invoice minus an agreed-upon fee.
how invoice factoring works

As mentioned, however, sometimes customers don’t pay. What this means to you depends on the factoring agreement you have in place. Under a recourse factoring agreement, your company must refund its percentage payment to the factor and write off the loss as bad debt. Under a non-recourse factoring agreement, the factoring company will write off the owed amount as bad debt.

When should a company use invoice factoring?

You’ll only want to employ invoice factoring services if it makes financial sense for your business. It might be a good idea if you have a negative cash flow and are consistently sitting on a large quantity of unpaid invoices.

Factoring companies will predominantly calculate their fees based on the volume and dollar value of the outstanding invoices, requiring lower rates for larger and more numerous debts. If you only send a handful of invoices each month, invoice factoring will likely not be cost-effective. 

Advantages of invoice factoring

  • Accelerates access to cash: With invoice factoring, you won’t need to wait until your customers get around to rendering payment. You’ll immediately have most of the funds owed in your bank account.
  • Delivers favorable financing terms: Typically, an invoice factoring agreement costs will be considerably lower than comparable interest payments were you to secure a bank loan for funding instead. These types of deals can often be closed more quickly.
  • Establishes predictable cash flows: Based on the contract you’ve set up with the factor, you’ll know the value and timing of incoming payments when you submit the invoice. With this insight, you can simplify planning or forecasting efforts.
  • Ignores your credit score: Factors are predominantly concerned with the credit risks associated with your customers since they pay. So, if you have a bad or non-existent credit history, closing an invoice factoring deal is often much easier than securing a loan.
  • Liberate staff: By outsourcing your A/R and collections efforts, you can free up your accounting staff to focus on more strategic activities.

Disadvantages of invoice factoring 

  • Reflects a major commitment: You can’t easily opt out of an invoice factoring agreement. Typically, these contracts will require you to hand over most, if not all, of your A/R processes for an extended period — often longer than one year. As discussed below, you might want to explore alternatives to invoice factoring, like A/R automation.  
  • Cedes control of customer relationships: By outsourcing your dunning management efforts, you expose your customers to an outside party you don’t directly oversee, potentially risking working relationships.
  • Making non-payment more punitive: If the buyer never pays and you have a recourse agreement, you will lose the entire invoice value and still need to pay the factoring company its fees.
  • Puts you at the mercy of customer financials: If you have a bad credit history, you can take measures to improve it. But since factoring companies are more interested in your customer’s credit rating and fiscal health, there’s little you can do to lower your rates.

Invoice factoring example 

Knotty by Nature (KbN) is a mid-sized lumber mill in the American Southwest that has recently faced a cash crisis and turned to invoice factoring to create more consistent cash flow. In late 2023, the business received an order from Ugh! My Arches is a standing desk manufacturer and long-term client for $25,000 worth of pine, which was delivered on Feb 1, 2024.

When the new invoice was created for Ugh!, KbN forwarded the document to its factoring company, Pay It Forward Ltd., which deposited 80% of its value to KbN’s bank account within 48 hours.

The factoring company then engaged in dunning efforts related to the outstanding invoice, and in just three weeks, Ugh! My Arches handed over full payment. 

With the invoice closed, Pay It Forward provided KbN with the remainder of its value — minus its 2% processing fee. In the end, Knotty by Nature paid $500 to collect the pine order, leaving it with $24,500.

Total invoice amount

$25,000

Initial payment (80% of invoice total)

$20,000

Remaining value (20% of invoice total)

$5,000

Factoring fee (2% of invoice total)

$500

Remainder payment (minus factoring fee)

$4,500

Realized invoice value

$24,500

Accounts receivable automation can reduce the need for invoice factoring

As previously noted, one of the primary motivations for signing an invoice factoring contract is to gain more nuanced control over cash flow and to simplify accounts receivable management. However, more cost-effective strategies exist to accomplish these same goals, such as deploying accounting automation software.

A competent A/R platform will help you:

  • Standardize and accelerate your invoicing efforts
  • Leveraging automated workflows to cut out unneeded wait times between process steps
  • Prevent outstanding debts from slipping through the cracks.
  • Provide opportunities for your accounting team to focus on more strategic efforts, improving job satisfaction while unlocking additional value. 

The right A/R automation platform can help you capture the common benefits of invoice factoring while avoiding its limitations — all at a lower price point.

Reduce unpaid invoices with Invoiced

Not all A/R automation platforms are created equal, so selecting the right solution is crucial for maximizing value and efficiency in your business operations. Our Accounts Receivable Automation software stands out:

  • Our innovative, AI-powered Smart Chasing technology empowers you to automate scheduled, multi-channel communication for your dunning efforts, saving your team time and money. 
  • Not only can you send automated e-mail reminders on a schedule, but our self-serve payments portal makes it fast and convenient for buyers to manage their orders, update payment information, and settle invoices promptly.
  • Our software includes a suite of pre-built reports and customizable dashboards, enabling you to delve into detailed analytics of your payment data and identify previously unnoticed patterns, opportunities, and issues.
  • Invoiced offers a variety of bi-directional integration opportunities, making our software easy to add to your established workflow and processes. 

By better controlling when and how you pay out invoices to your suppliers and vendors, you can reduce the amount of unpaid invoices and exert a much more nuanced control of your cash flow. 

Take the next step toward optimizing your financial workflows with our Accounts Receivable Automation or Accounts Payable Automation software by scheduling a demo today. 

Published on March 12, 2024
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