Invoice factoring is one method of arranging finance in the short term for businesses. It is an easier option with quick approval as compared to traditional bank loans.
Invoice factoring helps a business improve cash flows and manage working capital needs. It comes with outsourcing and financing costs.
Let us discuss the invoice factoring process and what it offers to a business.
What is Invoice Factoring?
Invoice factoring is considered the process of selling unpaid customer invoices to a third-party invoice factoring company.
Invoice factoring or account receivable factoring is the process of outsourcing outstanding collectibles. Outsourcing companies specializing in invoice factoring services offer advance payment against the arrangement.
Invoice factoring can be arranged with recourse and non-recourse contracts. A recourse invoice factoring is a standard and commonly used contract. It means if the third-party service provider fails to collect the outstanding invoices, the first party shall assume the responsibility again.
In a non-resource arrangement, all the responsibility and risks of outsourcing are transferred to the third-party service provider. However, non-recourse invoice factoring is a costly practice and is used only by large companies with special arrangements.
How Does Invoice Factoring Work?
A business with outstanding invoices and large accounts receivable amounts can outsource the collection amount to a third-party service provider.
The outsourcing company (the factor) charges financing and service fees to the applicant. The factor assesses the creditworthiness of the customers of the applicant.
The factor offers upfront cash to the applicant. The upfront cash percentage depends on the creditworthiness of the customers. However, most companies offer up to 90% of the total outstanding invoices in advance to the applicant.
The approval of invoice factoring applications is approved more quickly than traditional bank loans. Since, invoices include usually a grace period of 30,60, 90, or 120 days, the invoice factoring aims to offer quicker services than the normal collection system.
Once the factor collects outstanding invoices, it pays the remaining balance to the applicant. Usually, the arrangement is made on a recourse basis. It means all uncollected invoices are returned to the applicant.
Difference Between Invoice Factoring and Invoice Discounting
Both invoice factoring and invoice discounting offer similar benefits to a company. These methods help a company arrange cash quickly and improve the working capital.
Invoice discounting is the process of receiving loans against outstanding invoices. In other words, a company obtains a loan by pledging its outstanding invoices as collateral to the lender.
With invoice discounting, the responsibility of collecting unpaid invoices remains with the applicant. Since the lender does not assume risks of default for the outstanding invoices, the costs of invoice discounting are lower.
Unlike invoice factoring, the applicant needs to repay the borrowed money in an invoice discounting arrangement. In other words, discounting works like a line of credit or a short-term bank loan.
Invoice discounting works more like a short-term bank loan than invoice factoring. However, the business receives similar benefits of quick approval and easy application processing.
Costs of Invoice Factoring
The third-party service provider assumes risks of collecting unpaid invoices. Hence, it requires compensation for undertaking the risks. Service charges, financing costs, and other types of charges are the costs of invoice factoring.
The factoring fees average from 1% to 5% of the total outstanding invoices usually. However, these fees largely depend on the creditworthiness of the customers of the applicant for invoice factoring.
Another major factor in deciding the factoring fee is the average outstanding days for uncollected invoices.
Additionally, the factor can include some of these costs as well:
- Application and Closing Fees: The application fees are charged by some factors. It is also called the due diligence fee. Some factors also charge a closing fee to retain a small proportion of outstanding invoices.
- Monthly Fee: For regular and recurring arrangements, some factors may charge monthly charges as well.
- Termination Fee: Just like an early loan settlement cost, the invoice factoring may also come with the termination fee.
- Discount Fee: The discount fee is also charged by some factors for monthly invoice factoring arrangements where advance cash is arranged regularly.
Access to Invoice Factoring Facility
Invoice factoring is a common practice these days. Unlike the common notion, invoice factoring is available to small and large businesses equally.
Small businesses can also outsource their outstanding invoices. The purpose is to collect advance cash and manage the working capital. However, the factor will always assess the creditworthiness of the applicant for invoice factoring arrangements.
Invoice factoring with non-recourse arrangements is a costly method. Large companies outsource invoices with non-recourse contracts to reduce risks. However, the costs may not be feasible for smaller companies with a non-recourse contract.
When You Should Apply for Invoice Factoring?
Invoice factoring is an alternative financing option. Businesses with adequate cash reserves and smooth working capital do not need to apply for alternative financing.
Ideally, businesses looking for short-term financing solutions should consider invoice factoring. Also, companies with a large number of outstanding invoices can consider the option.
Other situations where a company can apply for invoice factoring are its low credit score, limited access to traditional bank loans, or bad credits from customers. However, the applicant must know that invoice factoring does not work like a credit line.
Invoice factoring is also a viable option for startups and new businesses. However, the risk of default of customers remains with the applicant through a recourse contract.
Although a business of any size can outsource invoice collection, the arrangement makes sense when invoices are taking longer than 90 days for collection. Applicants must also consider the costs associated with invoice factoring as compared to traditional loans.
Advantages of Invoice Factoring
Invoice factoring offers several advantages to businesses struggling with outstanding invoices and bad credits from customers.
Improving cash flow
Improved cash flow is the immediate benefit of invoice factoring. Businesses can receive cash immediately after approval within a few days.
Saving costs with borrowings
Unsecured bank loans can come with higher interest costs as well as covenants. Invoice factoring can save money through quick cash approval and lower interest costs.
No Collateral Requirement
Invoice factoring does not require an asset to be pledged as collateral. The application is approved on the basis of outstanding invoices and the creditworthiness of the applicant.
Some other benefits of invoice factoring include:
- Quick application approval
- Outsourcing the task to experts in the credit collection field
- Scalable financing solutions as customers can choose to outsource selective invoices.
- Customers can focus on the main activity of the business.
Disadvantages of Invoice Factoring
Invoice factoring comes with some disadvantages as well.
The factoring costs may range between 1% to 5%. In many cases, the invoice factoring costs can be higher than traditional short-term bank loans.
Loss of Control
Once a business outsources the invoices, it loses control over the collection process.
What if Customers Fail to Pay?
Most invoice factoring contracts come with a recourse clause. It means if the customers do not pay, the applicant will assume the responsibility of the default. It means the customer does not receive guaranteed payments of outstanding invoices.
Outsourcing invoices to a third-party collection agent may hamper customer relationships as well. It can affect the pricing and trade relationship between the applicant and its customers.