What Is Invoice Factoring? How Does It Work?

If you own a small business that frequently issues invoices to customers and vendors, you may have encountered times when an invoice is late or goes unpaid. It can be frustrating and worrisome when expected income is unavailable, leaving your business short on cash flow for necessary expenses.

There are options like business lines of credit or short-term business loans to provide cash flow. But in this case, you might also consider factoring your invoices to quickly access cash for your immediate needs. This type of financing allows you to leverage your unpaid invoices without applying for an actual loan.

Let’s walk through what invoice factoring is, how it works, and what business cases are a good fit for this type of funding.

Invoice Factoring Explained

Invoice factoring, also known as accounts receivable factoring, is a form of small business financing in which you sell your unpaid invoices to a factoring company. The factoring company gives you a percentage of the invoice value up front and pays you the balance once it’s paid by the customer (minus fees charged by the factoring company).

When financing through invoice factoring, you no longer own the invoices — the factoring company does. As a result, it’s important to choose a reputable company that you can trust to treat your customers with respect.

Recommended: What Is Debt Factoring?

How Does Invoice Factoring Work?

Invoice factoring involves selling your unpaid invoices to a factoring company, which then takes ownership of the invoices. Invoice factoring is technically not a small business loan; instead, you are selling something of value (a share of your accounts receivable) to the company.

Factoring companies will pay you a percentage of the invoice amount up front, which reflects the advance rate. Advance rates are typically based on how risky the transaction is for the factoring company.

Some industries, such as the medical industry, may be seen as higher risk, thus leading to lower advance rates — often ranging from 60% to 80%. Other types of businesses, such as staffing agencies, may receive advance rates of 80% to 90% or even higher.

Once the factoring company receives full payment from your customers, they provide you with the remaining invoice amount minus a factoring fee.

Here’s a quick look at the steps involved in factoring invoices:

1.   Choose a factoring company: It’s a good idea to shop around and pick a reputable company to work with.

2.   Submit invoices: To apply for factoring, you’ll need to provide invoices for approval.

3.   Receive advance: If approved, you’ll get an upfront payment (typically 60% to 90% of invoice value).

4.   Company collects payments: The factoring company collects payments from your customers.

5.   Receive balance: After payments are collected, you receive the remaining amount minus fees.

Recommended: Getting a Cash Flow Loan for Your Small Business

Recourse vs. Non-Recourse Factoring

You might be wondering: What happens if customers don’t pay their invoices?

With recourse factoring, the business is liable for paying the factoring company for any invoices that are left unpaid. This type of invoice factoring is most common because it’s less risky for the factoring companies.

With non-recourse factoring, the factoring company takes on most of the risk associated with unpaid invoices. Since non-recourse factoring causes the company to assume more risk, it may tack on a higher factoring rate or fee. Carefully consider whether the cash advance amount is worth the higher rate and compare factoring companies to see what terms they offer.

The Role of the Customer in Invoice Factoring

The factoring company takes on the task of collecting receivables from customers. That’s why the company looks at your customers’ creditworthiness more closely than yours: Your customers are the ones responsible for repaying the debt. If your customers’ ability to pay isn’t perceived as rock-solid, the factoring company may proffer less upfront cash on those invoices.

When to Consider Invoice Factoring for Your Business

Small businesses that need cash flow right away may benefit from invoice factoring. This is especially true for small companies that may not qualify for loans or may want to keep debt levels lower. Compared to a loan application, factoring invoices involves less paperwork and an easier approval process. There’s also no need for collateral.

Cash Flow Challenges

For small businesses with narrow margins, cash flow problems can loom large. Payroll and overhead aren’t cheap, and planning can be especially challenging for seasonal businesses. If you need to fend off a cash crunch, invoice factoring can often deliver 80% to 90% of the receivables’ value to your account within 24 to 48 hours.

Slow-Paying Customers

Some customers and/or certain industries can take longer to pay outstanding invoices. This may be a reason to offload those collections to a factoring company. At the same time, factoring companies are likely to offer lower advance rates for the invoices of slow-to-pay clients.

For example, transportation companies and staffing agencies pay reliably; their advances typically hover around 90%. Construction subcontractors may be offered around 75% for their invoices. Delays from insurance companies are common, so advance rates on health care–related invoices may dip as low as 65%.

Example of Invoice Factoring

To give you a better understanding of how invoice factoring works, let’s imagine you own a clothing store that sells large quantities of T-shirts to other companies.

1.   Complete sale and issue invoice: You sell $100,000 worth of T-shirts and invoice your customer with a due date in 60 days. If you wait 60 days for repayment, your business could face a cash flow shortage, threatening the well-being of your operation. So, you decide to look into options to help manage cash flow.

2.   Explore your options: You could use an online business loan or a credit card to get cash quickly. Because your customers are reliable and pay invoices in a timely manner, invoice factoring is also a suitable option.

3.   Sell to a factoring company: You sell the $100,000 invoice to a factoring company and agree to pay a factoring fee (sometimes called a factoring rate) of 5% of the invoice value per month. This is the factoring company’s compensation for handling the account receivable. Within 24 hours, the factoring company provides you with 80% of the invoice amount. You now have $80,000 to supplement cash flow and regular business operations.

80% of $100,000 = $80,000

4.   Collection of funds: The customer pays the factoring company within 30 days. Once it receives full repayment, the factoring company pays you the remaining invoice amount ($20,000) minus the factoring fee of 5%.

$20,000 – $5,000 (5% of $100,000) = $15,000 back to you

Keep in mind that this is a hypothetical example to illustrate how invoice factoring may work in a practical situation. Different invoice factoring services may offer various terms and conditions, which can affect how much money you receive up front and the final payment amount.

Invoice Factoring Rates and Fees

Invoice factoring companies generally make money through the factoring rates and fees they charge. Typically, you will see invoice factoring structured with one of the following:

•  Flat rate/fee: You pay a fixed percentage of the invoice to the factoring company. The rate doesn’t usually change — even if the customer pays late. Flat rates are generally less common than tiered or variable rates.

•  Tiered or variable rate/fee: A percentage of the invoice amount is regularly charged until the factoring company receives full repayment. The longer invoices go unpaid, the more you’ll owe in factoring fees.

For example, a factoring company may charge a factoring fee of 1% every 10 days until the invoice is paid; if it takes your customer 60 days to pay, the factoring company would keep roughly 6% of the invoice amount. Some factoring companies may increase the variable rate when the repayment takes longer.

Factoring rates and fees can be affected by:

•  The industry your business is in

•  Your customers’ ability to pay their invoices

•  The number and amounts of the invoices

•  Your business’s stability and creditworthiness

Additional Fees

Some factoring companies may also charge additional fees, including:

•  Application fees. These are charges for processing your application and setting up the account.

•  Invoice processing fees. These fees help cover the cost of things like credit checks and record keeping.

•  Service fees. These are charged in intervals to cover costs related to maintaining a current account with your factoring company.

•  Automated Clearing House (ACH) or bank wire fees. When funds are transferred between banks, there may be fees passed on to you from the factoring company.

•  Early termination fees. Some invoice factoring companies may charge a fee if you cancel your contract before the termination date.

•  Due diligence fees. This covers the cost of verifying the creditworthiness of the customers paying the invoices.

Pros and Cons of Small Business Invoice Factoring

Invoice factoring can be a useful tool for business owners in certain situations. However, it’s important to carefully consider the pros and cons of factoring invoices to avoid unnecessary expenses or added stress for your business.

Pros of Invoice Factoring

•  No collateral: With invoice factoring, your invoices serve in lieu of collateral. In most cases, you do not have to offer additional forms of collateral to be approved.

•  Maintain healthy cash flow: You can receive immediate cash to cover expenses and maintain healthy cash flow for your business between invoice payments.

•  An option for those with lower credit scores: Even if you don’t have good enough credit to get a business loan, invoice factoring may still be an option. Invoice factoring companies generally focus more on the value of the invoices and the credit scores of the businesses that owe those invoices than on the credit score of your business.

•  Outsource invoice collection: For some businesses, it may be helpful to pass the responsibility of collecting invoices to a factoring company so the business staff can focus on other responsibilities.

•  Spend on what you need: Unlike other types of small business loans (e.g., equipment financing), you aren’t restricted to spending the funds you receive on specific business expenses.

Cons of Invoice Factoring

•  Factoring companies have control: After you sell invoices to a factoring company, they may interact with your customers directly. You’ll want to make sure that the company is reputable and behaves ethically in their dealings with customers.

•  It’s typically expensive: With various fees and relatively high rates, invoice factoring can be costly — especially if customers delay payment.

•  Recourse if unpaid: Since there’s no guarantee that an invoice factoring company will be able to collect on all your invoices, the company may expect you to buy back the unpaid invoice or replace it with one of equal value. Additional fees may apply.

•  Approval may depend on customers: Invoice factoring companies want to ensure they will receive payment on the invoices they purchase from you. If your customers have a less-than-perfect repayment history, you may have a more difficult time getting approved.

Recommended: Accounts Payable vs Receivable: How They Compare

How Do Businesses Qualify for Invoice Factoring?

Factoring companies evaluate a few different things to determine if a business is eligible for this type of financing.

•  Invoices: Businesses must have outstanding invoices to sell to a factoring company, and the invoices should be from reputable clients with a history of timely payments.

•  Client creditworthiness: Factoring companies focus on the likelihood of timely payments from your clients rather than the credit history of your business. Therefore, clients that consistently pay their invoices on time are a must.

•  Business bank account: An established business bank account is essential to qualify for invoice factoring. Your business bank account will be used for the factoring company to deposit the advance and the remaining balance once the invoice is paid.

•  Accounts receivable reports: Detailed and accurate accounts receivable reports are necessary to demonstrate your business’s invoicing practices and the payment behavior of your clients. These reports help factoring companies assess the risk involved.

While the primary focus is on the creditworthiness of clients, factoring companies also look for signs of business stability. They consider factors like time in business, industry, and overall financial health. It’s also important for businesses to ensure there are no existing liens on their receivables. Factoring companies need a clear right to collect on the invoices, so any existing liens or claims can disqualify the business.

You can improve your chances of qualifying by maintaining good relationships with your clients, ensuring they are creditworthy and have good payment histories. Keeping financial records organized and accurate is also important, as it makes the evaluation process smoother and faster.

What Is a Factoring Company?

A factoring company is a financial institution that purchases a business’s outstanding invoices at a discount to provide immediate cash flow. The factoring company then takes on the responsibility of collecting payments from the business’s customers.

Factoring companies can be independent firms or divisions within larger financial institutions such as banks or credit unions. They specialize in providing working capital to businesses with long receivables cycles or that need quick cash for operational expenses. By selling your invoices to a factoring company, you can receive up to 90% of the invoice value up front. The company pays you the remaining balance, minus a factoring fee, once the customer settles the invoice.

Factoring companies typically cater to industries with extended payment terms, such as manufacturing, trucking, and staffing agencies. These lenders evaluate the creditworthiness of the business’s customers rather than the business itself, making this an accessible funding option for businesses that have poor or limited credit.

Invoice Factoring vs. Invoice Financing

While they sound similar, invoice factoring and invoice financing are two different financial products.

With invoice financing, your invoices are used as collateral to receive a cash advance rather than sold to a factoring company. You receive access to a percentage of the invoice amount either in the form of a line of credit or loan. Like other types of business loans, you pay interest on the amount you borrow.

Another key difference between invoice factoring and invoice financing: With invoice financing, you and your business are still responsible for collecting payment from your customers. As a result, invoice financing allows you to retain control over your invoices and the collections processes. This may be preferable if you’d rather deal with your customers directly.

Alternatives to Invoice Factoring

Invoice factoring is one of many options that can help businesses maintain cash flow and address funding needs. Here’s a look at some alternatives.

•   Inventory financing: This type of financing is used to pay for products that will be sold at some time in the future. The inventory acts as collateral for the loan.

•   Equipment financing: This is a type of loan used specifically to buy machinery, vehicles, or other business-related equipment. Here too, the purchased items act as loan collateral.

•   SBA loans: These are small business loans backed by the U.S. Small Business Administration (SBA) and offered by banks and approved SBA lenders.

•   Personal loans: An unsecured personal loan is based on your personal credit history (not business credit). Some, though not all, lenders will allow you to use funds from a personal loan for business expenses.

•   Commercial real estate loans: This type of business loan is specifically designed for purchasing real estate for business use, such as an office space, warehouse, or storefront.

•   Business line of credit: With this flexible form of business financing, you have access to a maximum amount of funding, or credit. You can borrow what you need (up to your credit limit) as you need it, and only pay interest on the amount you borrow.

•   Online business loans: Online lenders offer loan options similar to those from traditional banks but typically have a faster approval process and may have more options for people with lower credit scores.

•   Merchant cash advance: This type of funding allows small businesses (“merchants”) to get a cash advance for business expenses in return for a portion of their future sales or receivables.

The Takeaway

Invoice factoring is a method of financing in which a company gives you cash upfront in exchange for a percentage of your accounts receivable. The factoring company then contacts your customers to collect on unpaid invoices and keeps a small percentage as a fee. It’s a way for business owners to leverage the value of unpaid invoices without applying for a loan or committing to a repayment schedule.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

With one simple search, see if you qualify and explore quotes for your business.

FAQ

What are the disadvantages of invoice factoring?

The disadvantages of invoice factoring include high fees, potential impact on customer relationships, loss of control over accounts receivable, and the requirement of having creditworthy clients.

What is the average rate for invoice factoring?

The average rate for invoice factoring ranges from 1% to 5% of the invoice value per month.

Who can use invoice factoring?

Generally, any business with outstanding invoices and creditworthy clients can use invoice factoring. However, this type of financing tends to be more common in industries like manufacturing, trucking, and staffing.

Is invoice factoring considered a loan?

Invoice factoring is not a loan because it does not involve taking on additional debt. This makes factoring a reasonable option for small businesses that want cash immediately but may not qualify for loans or want to increase their debt load.

How quickly can a business get funds through invoice factoring?

Invoice factoring can often deliver 80% to 90% of the receivables’ value to a business bank account within 24 to 48 hours.

---

Photo credit: iStock/Jirapong

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

SOSMB-Q325-034