Invoice factoring: What it is, how it works, and when you should do it

From replacing equipment to paying bills, running a small business requires money—but you may not always have the cash flow when you need it.

Invoice factoring, also known as accounts receivable factoring, lets small businesses quickly access cash by using unpaid customer invoices. This financing solution can be valuable for businesses looking to overcome short-term cash flow needs. Let’s explore how invoice factoring works, what it costs, its pros and cons, and more:

• How factoring invoices works
• Why do small businesses factor invoices?
• Invoice factoring vs. bank loans
• Invoice financing vs. invoice factoring
• Pros and cons of factoring invoices
• Should your business factor invoices?
• Get paid with less hassle

How factoring invoices works

If your business offers customer financing by invoicing clients for services or products, you might be able to factor in invoices. When a business sells its unpaid invoices to a factoring company, it receives an upfront payment, usually a percentage of the total invoice value. The factoring company then collects the full payment from the customers, deducts a small fee for its services, and provides the remaining balance to the business.

Invoice factoring means a small business can turn its outstanding invoices into cash. Here’s how it works: 

1. Submit invoices: Your business submits the invoices you want to factor to a factoring company. 
2. Wait for approval: The factoring company will review the invoices to determine their eligibility and quote you a fee for their services. 
3. Get a cash advance: Upon approval, the factoring company pays you a certain percentage of the invoices upfront, typically between 80% and 90% of the total value.
4. Factoring company collects payment: The factoring company becomes the invoice owner, removing it from your balance sheet and taking responsibility for payment collection. 
5. Collect remaining payment: After the factoring company collects payment for the invoices, it’ll pay you the remaining balance—minus any fees.

Factoring companies turn a profit on your unpaid invoices by charging you a factoring fee—usually between 1% and 5% of the total invoice value. The exact fee will depend on the amount of the invoices and the creditworthiness of your customers.

Example of invoice factoring

Say your small business needs $20,000 to replace some necessary equipment quickly, but you don’t have the working capital to do so. Rather than reaching out to a traditional bank for a loan, you decide to take a look at your accounts receivable.

You notice you have $25,000 in outstanding invoices and decide to sell your accounts receivable to an invoice factoring company. The company agrees to buy your accounts receivable for the value of the invoices minus a factoring fee of 4%.

Thus, the invoice factoring service will pay you a total of $24,000 ($25,000 x 96%) for the invoices. Typically, you will get a cash advance for a portion of the total amount within a few business days. 

After the factoring company collects all payments for the invoices, they’ll send you the remaining balance.

Using our example, here’s what the invoice factoring process looks like: 

• Invoice value: $25,000
• Fee (4% as an example): $1,000
• Initial cash advance (85% of the invoice after fee): $20,4000
• Remaining advance: $3,600 
• Total you’ll receive: $24,000

Why do small businesses factor invoices?

Factoring invoices can be a convenient solution to access immediate funds without having to wait for payment from clients. Small businesses often choose to do invoice factoring for a variety of reasons, such as: 

• They need immediate cash flow: Invoice factoring provides small businesses with quick access to funds to address cash flow problems and meet immediate financial obligations.
• They can avoid debt: Small business invoice factoring does not require taking on additional debt, unlike traditional bank loans. This can be useful for small businesses that may not qualify for loans or want to avoid increasing their debt load.
• They want flexible financing: You can factor invoices as needed, allowing small businesses to selectively factor in certain invoices rather than committing to a long-term loan. This flexibility can be valuable for managing fluctuating cash flow.
• They can grow their business: The immediate cash from factoring can help small businesses fund growth initiatives, such as purchasing new equipment or inventory, without waiting for customer payments.

Small businesses often struggle with late-paying clients, which can create a strain on their finances. If you want to streamline invoice factoring and better manage your cash flow, consider using accounting software.

Invoice factoring vs. bank loans

Invoice factoring is not technically a loan. A bank loan is money you have to pay back. Instead, with invoice factoring, a company buys your invoices in exchange for cash. 

These services look at your customer’s creditworthiness more closely than your business credit. That’s because your customers are the ones responsible for repaying the debt, not you.

Invoice financing vs. invoice factoring

Invoice factoring is one way to use your outstanding invoices to access cash. The other kind of accounts receivable financing is invoice financing. Similar to factoring, invoice financing allows businesses to obtain a cash advance by borrowing against unpaid invoices. 

The difference is that, instead of selling invoices, you’ll have to repay your lender or invoice financing company the amount you borrow. Unlike factoring, invoice financing is a loan or line of credit.

Pros and cons of factoring invoices

Invoice factoring can work for small businesses needing immediate cash flow. However, it comes with other benefits like: 

• Quick access to cash: Because the application process is fast and requires minimal paperwork, small business owners can gain access to working capital more efficiently.
• Simplified approval: The approval process is less rigorous than a typical loan application process where lenders consider things like your personal credit score.
• No collateral needed: Unlike loans, invoice factoring doesn’t require any collateral, which can be beneficial for businesses with few assets. 

On the other hand, small business invoice factoring also comes with downsides. For example: 

• Cost: While invoice factoring allows you to get cash quickly, it can end up being more costly than other forms of financing. It can also lower your profitability due to ‌fees. 
• Availability: Factoring invoices doesn’t work for all business models. If your business doesn’t use invoicing to bill customers, you won’t have any invoices to convert to cash.
• Loss of control: When you factor in invoices, the factoring company takes over the invoice collection process and interacts directly with your customers. 

Also, note that invoice factoring services rely on the creditworthiness of the customers or clients who owe the invoices. If a client defaults or is unable to pay, your business may have to repay the factoring company.

Should your business factor invoices?

Growing businesses that don't have the time or credit to get a bank loan often turn to invoice factoring. It can help improve cash flow and revenue stability but can also help fund operations or pursue growth opportunities.

If your business has high profit margins and can afford to wait for customer payments, you may not need to look at options such as invoice factoring.

Note that factoring companies may have specific requirements. These can include:

• Minimum length of time in business
• Minimum invoice volumes
• Completed application
• Business bank account
• Accounts receivable aging report

Some companies may also have industry restrictions, so look into their requirements before applying.

Get paid with less hassle

If your business is experiencing cash flow problems and you need access to immediate cash, invoice factoring can be a viable option. However, there are drawbacks and fees for accounts receivable factoring. The good news is there are more small business financing options like equipment financing and lines of credit if invoice factoring isn’t the right fit for you. 

One of the easiest ways to prevent cash flow issues is to actively manage your accounts receivable. Accounting software like QuickBooks Online can help you track invoices and generate reports to monitor your financial health.