What is Invoice Factoring and How Does It Improve Cash Flow?

Run Your Business Jul 17, 2020

Are you facing cash flow problems with too much cash tied up in accounts receivables? Invoice factoring can tide you over by providing you an advance on your unpaid invoices.

Boost your business cash flow with invoice factoring
Invoice factoring can be used to boost your business cash flow when too much cash is tied up in your accounts receivable. Karolina Grabowska / Pexels

What is Invoice Factoring?

Invoice factoring is a financing method for businesses where unpaid invoices are sold to factoring businesses. These factoring businesses pay a percentage of the value of these invoices and rebates the rest (after deducting fees) once your customer has paid. Although utilizing invoice factoring results in a lower profit-margin, you get to enjoy a stable cash flow.

Some businesses miss out on crucial information in their invoices, resulting in late payment. Improving your invoice layout is an easy way to reduce the chances of delayed payment. Check out our tips on invoicing in our comprehensive invoice guide here.

How does Invoice Factoring Improve My Cash Flow?

Cash flow management is an integral part of sustaining your business. The ideal scenario is for your cash inflows to be more than your cash outflows.

By selling outstanding invoices to an invoice factoring company, you can increase positive cash flow and direct it to finance other aspects of your business.

Curious to learn more about cash flow statements? Check out our cash flow guide here.

Factoring companies take a portion of your invoice value as a commission fee
Factoring companies earn profit by charging a portion of your invoice value as a service fee. Karolina Grabowska / Pexels

Types of Invoice Factoring

Invoice factoring can be categorized in two ways:

  • The party liable in the case of bad debt
  • The number of invoices a business decides to sell to the factoring company

The Party Liable in the Case of Bad Debt

1. Recourse Factoring

In recourse factoring, it is your business's responsibility to bear the outstanding amount if your customer defaults on their debt.

Recourse factoring is the most common practice for factoring companies as it protects them from losing money if your customer does not pay up. If the customer fails to make the payment, you must return the advance to the factoring company.

2. Non-Recourse Factoring

For non-recourse factoring, the factoring company takes on the liability of bad debt if the customer defaults on payment. Only in certain situations (such as the customer refusing to pay due to faulty goods) can the factoring company claw back the advance given.

As they are taking on higher risk, it is typical for the factoring organization to do thorough background checks on your company and your customers. Due to the more significant risk and amount of time and resources spent, the company charges a higher commission rate or fee.

Number of Invoices Involved

1. Whole-Turnover Factoring

In whole-turnover factoring, all invoices issued to customers are given to the factoring company for collection. A contract of at least 12 months typically is signed between the business and the factoring company. This approach is useful when the firm does not have a credit control process. It can rely on the factoring company's established procedures and professionalism in the collection of accounts receivable.

2. Selective Factoring

Selective factoring (also known as partial debt financing) grants your business the flexibility to choose which invoices to factor and is useful when you can identify customers who regularly pay on time to save on unnecessary factoring costs. This flexibility usually means a higher commission rate than whole-turnover, but a lower price than spot factoring. Businesses that employ this method must have a credit control process for the invoices they decide to handle on their own.

3. Spot Factoring

With the most flexibility but the highest commission rate, spot factoring allows you to factor a single invoice or load. Due to expensive fees, this method is uncommonly used unless a business urgently needs cash.

Can't afford to earn less with invoice factoring? We share 9 must-have invoice traits that ensure that your clients have the information they need to pay you on time.

Other than providing an advance on your unpaid invoices, factoring companies are equipped with credit control processes that you can benefit from.
Factoring companies can support your business with credit control management. Cottonbro / Pexels

Benefits of Invoice Factoring

1. A Reliable Source of Cash Flow

When you sell outstanding invoices to a factoring company, they only deduct the fee from the value of the invoice in the form of commission or interest. It does not involve incurring debt, and it is easier to qualify for than a bank loan.

Most factoring companies pay a percentage of the invoice's value before the customer pays so you instantly get some cash upfront. Additionally, if your business has sufficient capital, you can take up new jobs without relying on payment of previously fulfilled orders, increasing your potential earnings.

2. Faster Turnaround Time as Compared to Taking Up a Loan

The application process for a bank loan can take up to a few months. On the other hand, invoice factoring can provide you with cash resources as fast as the same day!

3. Suitable for Businesses with Poor Credit Score

One common blocker for acquiring a bank loan is the credit score of the applicant. On the other hand, factoring companies are more concerned with the customer's credit quality than your business's as they collect the unpaid amount from the customer. Even with a poor credit score, you might still be able to sell your invoices to a factoring company.

4. Frees Up Resources Spent on Chasing Late Payments

By engaging an invoice factoring company, you are outsourcing your payment collection and credit control to them. Freed up resources can be used in other aspects of your business.

5. Can be Used to Support Longer Payment Terms

Some businesses offer longer payment terms that are more favorable to their clients to maintain an excellent supplier-customer relationship. By strategically using invoice factoring, you do not need to suffer from having periods of poor cash flow due to slow payments.

Invoice factoring can be used to provide a steady cash flow when leveraging long payment terms with your customers.
When providing longer payment terms to improve your customer-supplier relationship, you can use invoice factoring to facilitate a steady cash inflow. Photo by Chris Liverani / Unsplash

Conclusion

Invoice factoring is a viable option for alternative financing, even for startups and small businesses. Many factors, such as the customer's reliability in regular payment and your payment terms, can help you identify the factoring type ideal for your business.

Used the right way, invoice factoring can improve your cash flow without taking up additional liabilities.

To learn more about managing your cash flow, check out our Cash Flow Statement guide.

Looking for an accounting software?

Deskera Books is a reliable cloud-based ERP solution that can help you in generating and managing e-invoices for your small business needs. Start a free 30-day trial here!

If you are based in Singapore, we also prepared a guide on e-invoicing that caters to small-medium enterprises (SMEs) that are considering digital accounting.

Addie Ho

Passionate about learning something new every day, Addie is part of Deskera's Product team that works on upcoming features and strives on improving user experience.

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