- Invoice factoring allows business owners to borrow against their unpaid invoices.
- This funding option can be useful for businesses that aren't typically approved for conventional funding.
- Invoice factoring is more expensive than other financing options.
- This article is for small business owners interested in turning their unpaid invoices into cash.
Invoice factoring is a type of financing that allows business owners to get paid faster on invoices for work they’ve already performed. While factoring isn't ideal for all industries and is more expensive than other types of financing, it's a great option for many business owners in certain industries or with certain credit profiles.
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Invoice factoring is important because it offers fast funding for businesses that qualify. In these cases, by working with a factoring company, you can effectively sell payments you're owed for outstanding invoices and shift your risks to a factoring company if your client pays late or fails to pay their invoice.
What is invoice factoring?
Invoice factoring is a business financing tool that offers quicker funding than many other types of loans. Factoring also makes it easier for business owners with questionable credit to get funding, because the owner's credit isn't really important – it's their clients' creditworthiness that matters.
[Read Related: Financing Options That Bypass Traditional Banks]
With these advantages, invoice factoring is especially prevalent in industries that don't lend themselves well to conventional financing solutions, such as these types of businesses:
- Logistics companies
- Staffing companies
- Consultants
- Attorneys
How does invoice factoring work?
Only companies that invoice clients are eligible for factoring, so the factoring process starts with your business performing work for a client. Once the work is complete, you invoice your client. If you decide you need cash faster than the client typically pays you, you can apply with a factoring company.
After your business is approved to work with a factoring company, you identify the individual invoices you want to borrow against. The factoring company then vets the client to make sure they have a strong history of paying their invoices.
If the factoring company approves the invoice, you assign the invoice to the factoring company. The factoring company then advances your business a portion of the money you're owed on the invoice (typically 80% to 90%).
Once you receive your advance against the invoice, you can use the money however you want – such as for expansion, equipment or payroll. The factoring company takes responsibility for collecting the invoice, and after your client pays the full invoice, the factoring company sends you any funds left after the loan is repaid, along with interest and any other fees.
What is the difference between invoice factoring and invoice financing?
Invoice financing and factoring are similar but have several key differences. In order to use invoice financing, you have to apply with a lender and get approval to borrow against certain invoices. You can then get an advance on the amount your client owes you.
However, when you use invoice financing, your business is still responsible for collecting on the invoice. Once you do, you use the payment to pay back your loan, plus interest and fees. After you've repaid the loan, you may be able to borrow against other invoices.
With invoice factoring, on the other hand, you effectively sell your invoices to a factoring company. [Read Related: Bootstrapping or Equity Funding]
These are some other key differences between factoring and invoice financing:
- Importance of credit: In invoice financing, your business's creditworthiness is a major consideration. In factoring, your clients' credit is far more important.
- Responsibility for collections: Factoring companies collect on the invoices you assign them and forward any additional proceeds to your business. In invoice financing, you collect on the invoices and use the proceeds to pay off your loan.
- Reborrowing: In invoice financing, you typically need to repay your loans before borrowing again. In factoring, you can typically factor any approved invoices sent to approved client companies, regardless of your business's outstanding loans.
So, while factoring typically allows you to borrow against any outstanding invoices you've sent to approved clients, invoice financing has an underwriting process much more similar to conventional loan products.
How much does invoice factoring cost?
Invoice factoring is one of the easier types of financing for businesses to qualify for, and it allows you to get cash very quickly – much faster than most client companies pay their invoices. The downside is that factoring is one of the most expensive forms of business financing available.
- Advance rates: While this isn't a direct cost, most factoring companies will only advance you up to 80% or 90% of the value of your invoices. The factoring company holds the rest in reserve until your client pays the invoice, and it deducts interest and fees.
- Interest: Factoring companies' interest rates typically range from 0.5% to 4% per month, which is much higher than more conventional financing's interest rates.
- Late payment fee: Factoring companies may charge you a fee if one of your clients pays their invoice after it's due.
- Returned check fees: If one of your clients pays the factoring company but their check doesn't clear, the factoring company may charge you a penalty.
- Wire transfer fees: Some factoring companies charge fees to process wire transfers, either when distributing advances to you or receiving payments from your clients.
The costs of factoring can be much higher than for other types of financing. There are often some ways to reduce costs, but these vary by factoring company. For example, borrowers in certain industries (such as healthcare) may receive lower interest rates than others. You may also save money if you handle payments electronically. Of course, the sooner your clients pay their invoices, the lower your fees will be.
[Looking for additional funding options? Read: How to Get a Bank Loan for Your Small Business]
Pros and cons of factoring
While there are several advantages to using factoring as a form of business financing, it also has drawbacks. These pros and cons make factoring ideal for some businesses in certain industries and a poor solution for others.
Pros
- Quick application process: Unlike conventional financing, invoice factoring involves more vetting of your clients than of your business.
- Shift liability: If you factor your invoices, you are no longer responsible for collecting payments – the factoring company handles that.
- Ease of borrowing again: When you factor invoices, you often don't need to wait for previous invoices to be paid before factoring more.
- Options for bad credit: If you have bad credit and can't get approved for other business loan solutions, you can often still factor your invoices to help grow your business or cover operating costs.
- Fast funding: Factoring lets you get cash as soon as the next day in some cases, rather than waiting 30 days or more for your clients to pay you.
Cons
- Narrow eligibility: Only businesses that invoice their clients can qualify for factoring.
- Client creditworthiness requirement: While business owners with bad credit typically have no difficulty financing invoices, you need to have creditworthy clients in order to factor your invoices.
- Low advance rates: Factoring companies only advance you 80% to 90% of the amount you invoice your client.
- High interest rates: Factoring companies charge around 1% to 4% per month. This works out to 15% to 35% APR, which is about the same as credit card interest and much higher than the interest on other types of business loans.
- Additional fees: Factoring companies often charge additional fees for things such as wire transfers, returned checks, and late collections, even though you have no ability to ensure timely payment from your client after assigning their invoice to a factoring company.
This last point is worth highlighting, because when you factor an invoice, you effectively sell that invoice to the factoring company and give up any right to collect payment yourself. Even though you can't ensure the collection of the invoice, the interest you pay is based on how long it takes your client to pay the invoice.
What to look for in a factoring company
Like other lenders, factoring companies come in all shapes and sizes. Each has its own strengths and limitations as well as specialties. If you think invoice factoring may be a good way to help you finance your business, consider these aspects being picking a lender:
- Industry specialty: Most factoring companies specialize in one or more industries or certain sizes of business. Find one that understands your industry and your needs.
- Low interest rates: The interest on invoice factoring can be very high, so make sure you understand the rates your potential factoring company charges compared to its competitors.
- High advance rate: Factoring companies limit how much they will advance borrowers relative to the size of the invoice. Work with a factoring company that lets you access as much of your money early as possible.
- Online invoice management: Good factoring companies have online platforms where you can log in to check the status of invoices you've factored and submit new invoices for factoring.
- Few additional fees: Make sure you won't be blindsided by unexpected charges.
- Fast funding: Factoring companies should give you access to your cash within a day or two.
- Easy renewal process: Once you're approved to work with a factoring company and it has approved one of your clients, the process for factoring additional invoices should be quick and easy.
Invoice factoring is a fast, easy form of business financing for certain qualifying businesses. While factoring involves higher interest than many other types of business financing, the right factoring company can be a great partner to give you quick access to cash for work you've already performed, helping you operate and grow your company.