What else do other businesses do for working capital needs? And most importantly, if you’ve commercial or government institutional clients having long terms of credits, you might have to think about your short-term financing needs!
Small and medium business enterprises often struggle to get finance to meet their short-term capital needs. Some businesses in their growth stage also face a hard time maintaining their positive cashflows.
However, some business organizations qualify for bank loans and raise capital to meet their short-term and long-term needs.
If bank financing is not your option, what will you do?
There is a simple solution for growth-stage startups and small businesses.
Transferring your invoices without resources can help you to get out of the cash flow shortage cyclone.
Another term used for this is invoice factoring, and it is a financing strategy used by many businesses.
In this article, we are going to look into the process of invoice factoring. How invoice factoring differs from account receivables factoring will also be discussed in the blog. So let’s get in.
What Is Invoice Factoring?
Invoice factoring is often defined as selling outstanding invoices to some financial institutions at a discounted price. If we formally define invoice factoring, the definition will be,
Invoice factoring is a business transaction of discounting the outstanding invoices for credit sales with a third-party financial institution or factor agent. The purpose of invoice factoring is to solve the cash flow shortage or funding for paying the outstanding expenses of a business.
Invoice factoring is often confused with account receivables financing. Whereas account receivables financing is a part of invoice factoring. However, the origin of account receivables financing and invoice factoring is the same.
The concept of invoice factoring was employed in its most vague form during 2000 B.C. Between the 1300s and 1600s, it was adopted by Britain and American merchants.
Later on, rules and regulations were made for invoice factoring to commercialize it as a financing strategy. In the 1900s and 2000s, more advancements were made in the field of invoice factoring.
Finally, we’re here with cloud-based software and seamless processes for quick factoring and instant access to cash.
When To Go For Invoice Factoring?
Before you chose to discount your invoices, a question might come to your mind.
Should you go for invoice factoring? Is it the right time to choose invoice factoring for cash flow requirements?
Here is a checklist; if most things on this checklist relate to your business needs, it’s the right time to discount your invoices.
- You are running short on your business’s operational cash flow
- Your business does not meet the requirements to qualify for a bank loan
- There is a dire need for short-term cash for meeting your outstanding obligations
- Adding loan will affect your business’s financial health
- Your business is in the growth stage
- The net worth of your business is negative therefore making it riskier to add more loan
- You don’t want to keep your assets as collateral in the bank or financial institutions
Which Business Industries Most Commonly Use Invoice Factoring?
Certain business industries and companies employ the discounting of their invoices more often than other industries.
The most common industries and types of companies include:
- Staffing and Human Resource Companies
- Construction Industries where the cash receipts are often delayed for longer periods
- Manufacturing Industry because many times manufacturer require cash to procure raw material to complete orders
- Apparel Industry
- Distribution
- Commercial Service Providers
- Transportation Industry
How Does Invoice Factoring Work?
Now let’s get into the process of invoice factoring and how does it work.
Step 1: Sales Of Goods And Services On Credit Terms
The first step to acquiring the cash as a result of discounting your invoices is to make sales. Once the sale is made, the invoice for sales on credit terms of 30 days to 90 days is created.
The invoice is sent to the client for a consensus on the payment terms. The client accepts the terms, and the invoice is returned.
Step 2: Setting Up Account With Factor Agent
The next step is to find a compatible factor agent according to your needs and requirements. After the preliminary discussion and deciding about the terms & conditions of factoring, the account is set up with the factoring agent.
Step 3: Presenting Your Outstanding Invoices To Factor
The next step is to present your invoices which you want to discount. The most prominent feature of invoice discounting is that the selling company can choose which invoices to discount and which ones to keep within the company.
The other ways of financing, like account receivable financing, don’t give autonomy to do selective discounting. The factoring company will review the invoices and confirm the creditworthiness of the company’s clients.
Step 4: Cash Proceeds Are Issued To The Business
After the approval of the invoices, the factoring company will instantly issue the agreed-upon percentage of cash to the selling company.
In most cases, 70% to 90% of the invoice value is issued instantly. Whereas the remaining amount is kept as a reserve until the payments are collected.
Step 5: Debt Is Collected By The Factor
According to credit terms, when the date of cash collection arrives, the factoring company attempts to collect the amount from debtors. The accounts are settled, and the proceeds are received by the factoring agent.
Step 6: A Temporary Reserve Account Is Made For Payment Recording
The selling company will create a temporary reserve account to receive the payment proceeds from the reserve held by the factoring company.
Step 7: Fees For Factoring Is Deducted, And Amount Is Issued To Selling Company
Now the factoring company deducts its fees from the reserve and issues the remaining amount to the selling company. The selling company will write off the temporary reserve account by debiting cash and factoring expenses.
Example And Journal Entries
Let’s comprehend the concept of invoice factoring with the help of an example.
ABC company has sales to another company, LMN, amounting to $15,000,000. The terms of credit are agreed upon between the two companies. The amount is due 60 days from the day of the invoice.
The journal entry will be passed as:
| Date | Description | L.F | Debit ($) | Credit($) |
| Sales Account | 15,000,000 | |||
| Company LMN Account | 15,000,000 |
Company ABC presented the invoice to factoring agent Alpha Inc. They will review the invoices and analyze the creditworthiness of company ABC’s client.
After satisfaction, the invoices are accepted, and an agreed-upon amount of 80% is issued to company ABC.
The journal entry in books of company ABC will be:
| Date | Description | L.F | Debit ($) | Credit($) |
| Cash | 12,000,000 | |||
| Due From Factor(Holdback) | 3,000,000 | |||
| Account Receivables | 15,000,000 |
Once the day of payment arrives, the company will attempt to collect payment from the selling company’s client, LMN company.
Alpha Inc. will deduct the fees for the discounting which is 2% of the invoice value. The remaining amount will be issued to the company ABC.
The journal entry for this transaction will be passed on as:
| Date | Description | L.F | Debit ($) | Credit($) |
| Cash | 2,700,000 | |||
| Commission or Fees | 3,00,000 | |||
| Due From Factor(Holdback) | 3,000,000 |
What Is Cost Of Invoice Factoring?
Whenever a business is considering to opt invoice factoring as a financing strategy, the cost is an important concern!
In most scenarios, the percentage method is used to calculate the fees of the factoring company. The cost range between 1% to 3% of the invoice value in most cases. However, if we talk about calculating the cost of invoice factoring, there are two methods.
- A flat rate is applied that is decided by the consensus of both selling and buying company
- Percentage method where the percentage value of the invoice is charged by the factoring agent as a commission
Invoice Factoring Vs. Account Receivables Factoring
A big misconception that often exists in the industry is that invoice factoring is another name for account receivables factoring. It is true to an extent but using the terms interchangeably creates confusion.
There are some distinguishing features of both. However, one main difference is that factoring is a broader term and account receivables financing or factoring is just a part of it.
In the account receivables factoring, or more appropriately account receivables financing, the factoring company doesn’t risk uncollectible invoices. In case of bad debts, a factoring company can demand the money back from the selling company.
The invoice factoring in its purest form is the selling of invoices and the associated risks.
The given table below will further clarify the difference between the two methods of discounting.
| Invoice Factoring | Account Receivables Financing |
| Purchase of invoices at discounted price | It is like a short-term loan where account receivables are kept as collateral |
| Easy to get | Mostly requires the business to have a minimum limit of sales per month |
| It has a simple fee structure | Since the risk is shared between selling and factoring companies, the fees or commission charged is lower than invoice factoring |
Conclusion
Many people confuse invoice factoring with the concept of account receivables financing, whereas the reality is different. There are two types of factoring: with a resource or without resource factoring.
In the transfer of resources, the factoring company doesn’t risk bad debts and can claim money from selling the company if bad debt occurs. This is often known as account receivables factoring or financing.
Whereas this blog has encompassed the concept of invoice factoring in detail. We hope that now you can differentiate between two concepts and choose one type that best suits your business needs.