What’s it: Invoice factoring is a financing arrangement in which a company sells its invoices receivable to a finance company (called a factor or factoring company) in exchange for liquidity. The factoring company will pay cash from the invoice value sold and collect it from the customer. The credit risk between the two is divided according to the agreement, where sometimes the factoring company may bear the risk of bad credit.
Invoicing factoring is a potential source of short-term funding. Companies usually use this service when they have accumulated invoices and need cash immediately for their working capital.
How do accounts receivable invoices appear?
Your company may sell products not always in cash but on credit. Your customer gets the product and pays you later, usually around 30 days after receiving the item.
Companies provide credit sales facilities to stimulate purchases and relieve customer cash. That allows your customers to buy without worrying about having to pay for it right away. For example, suppose your customer purchases raw materials for their production. By buying on credit, they can make cash by processing raw materials and using the sales money to pay you.
Your company trusts customers to pay bills before the due date, enabling a loyal business relationship. And such credit facilities can encourage more purchases. But, because money is tied to the customer, you also have to balance the potential for increased sales with cash flow risk.
Cash flow risk is higher when your customers are late paying. This is because the longer their receivables remain unpaid, the less cash your company holds to use for your other expenses, such as payments to suppliers and paying off loans.
Why invoice factoring is important for companies
Several reasons explain why invoice factoring is important for companies. Let’s discuss two of them:
Increase liquidity. With a factoring service, your company doesn’t have to wait for customers to pay their bills. The factoring company will pay your unpaid bills quickly, perhaps 24 hours, allowing you to raise cash for your working capital. You no longer need to bill customers. With the money you earn from factoring companies, you can use it for various purposes, such as buying inventory or paying vendors according to a schedule.
Better budgeting. You can use accounts receivable to predict future cash inflows, which is vital in budgeting. In addition, your accounting and finance department can use cash flow forecasts to prepare for future expenses. And, you can use factoring services when many of your bills pile up, making cash inflows not match what was budgeted.
How does invoice factoring work
Invoice factoring is a potential source of short-term financing for your business. You sell the customer’s bill to a factoring company, and in return, you receive a cash payment. Then, the factoring company collects payments directly from your customers. That way, you can increase their cash flow stability without having to mess around with billing customers.
How invoice factoring works more or less like this:
- Your company provides goods or services to customers. But, instead of requiring a cash payment, you allow the customer to pay for it later. You issue invoices to their customers.
- Ideally, you wait for the customer to pay the amount owed in full according to the time period you set. However, sometimes you may need cash sooner. Or maybe it’s hard to bill your customers, and they’re in arrears to make payments. Therefore, instead of waiting for your customer to transfer money, you sell the bill to a factoring company.
- You get a cash payment, usually up to 80-90% of the amount billed after the factoring company verifies and ensures your invoice is valid. The rest, 10-20%, you will receive after the customer pays in full to the factoring company.
- So, your customers will no longer pay their bills to you but to the factoring company. Sometimes, the factoring company may have to work hard to catch up on invoice payments to customers if necessary. And that is the specialty of their work.
When should a company use factoring?
Companies usually use factoring services when they have outstanding invoices and need cash urgently. Or they have trouble billing customers and handing them over to a specialized company.
Some customers pay during the time period you set. Others may be late paying and become bad debts, requiring your company to put more effort into collecting payments. And, during that period, you may need cash to pay for routine expenses such as suppliers and interest on loans.
Pursuing payments to customers takes effort. And the company may not specialize in this. So, selling invoices to a factoring company is a reasonable alternative for them. They can get cash fast and easily. In some cases, the factoring company will pay you within 24 hours.
How do factoring companies make money?
Factoring companies earn money by charging fees. They will not pay you in full, say 80-90% of the total bill to your customer. And once they successfully collect payments from customers, they will pay you the rest, 10-20% less factoring fees. So, they will pay your company in two installments.
What are the types of factoring?
Often, customers are unable to pay their bills. And that poses a risk. How your company and the factoring company share the risk, there are two types of factoring arrangements:
- With recourse factoring – your company bears the risk. The factoring company has the option to sell bad debts to your company. In other words, you agree to assume some of the risk involved in the transaction.
- Without recourse factoring – the factoring company bears the full credit risk. Your company does not risk uncollectible receivables because the factoring company cannot resell receivables that have failed to be billed or are past due to you.
How is invoice factoring different from invoice financing?
Sometimes, invoice financing is misinterpreted and is considered the same as invoice factoring. Both are sources of short-term financing. However, the two are different.
Invoicing factoring. Your company sells invoices to a factoring company, and as compensation, you get cash after deducting expenses. How credit risk is divided depends on the arrangement as described in the section above. After selling the invoice, your company is not involved in billing your customers.
Invoice financing. Your company uses invoices as collateral for a down payment. However, your company remains responsible for collecting payments from customers.