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Business owners looking to fill gaps in cash flow or improve cash flow management usually have lots of questions about invoice factoring, but one thing that’s often overlooked is an explanation of what exactly it is, and how it works. Here’s a simple explanation.
What Is Invoice Factoring?
Invoice factoring is a kind of accounts receivable financing designed to improve cash flow. A business sells their outstanding invoices to a factoring company who pays them ahead of net terms. The business’ customer then pays the invoice to the factoring company when it’s due. Invoice factoring also goes by the terms accounts receivable factoring or receivable financing.
It’s important to note that this is different from invoice financing, where a factoring company still gives a business owner cash for their invoice, but the business owner pays back the invoice amount themselves, plus a fee. (Find out how to choose between invoice factoring vs invoice financing.)
This simple definition doesn’t tell the whole story about factoring. To understand factoring and why many businesses use it, it’s helpful to understand what it is not. There are a lot of misconceptions about factoring that have given it a bad reputation.
It’s not a loan; business owners don’t have to worry about paying the money back because their customer pays the factoring company. Most importantly, choosing to factor invoices doesn’t mean a business is struggling or can’t reliably serve its customers. Add to this perception that many traditional factoring companies charge hidden fees, don’t fund the full invoice amount, and take weeks to pay, and you can see why some people have a bad impression of factoring.
Thankfully, the truth couldn’t be more different: Invoice factoring makes businesses more successful when they need to maintain their cash flow in the face of long invoice payment terms. (In fact, it often helps business owners stress less about their cash flow situation!) Let’s get more specific.
Invoice Factoring Example: How It Works
This is more or less what you can expect when you factor an invoice. Let’s look at how it works through an example.
- Business owner Sally of Sally’s Cookies completes an application for invoice factoring. After she has done her shopping and found a short list of partners who might be the right fit, she applies to factor invoices and sends in a few documents.
- Factoring company reviews and approves application. The factoring company does their due diligence of verifying the Sally’s identity and her company. This also includes checking that her business is legally established, is up-to-date on taxes, and doesn’t have liens on accounts receivable. (Many factoring companies will find ways to work with businesses if they have these issues.)
- Sally submits her outstanding invoices for funding. Sally’s company sells cookies to Target, and has about $300,000 in invoices she’d like to have paid early to boost her cash flow, so she can take on a new contract with Wal-Mart. It’s important the be aware that traditional invoice factoring companies often require a business to factor all their invoices for the duration of a contract. With many newer companies, you can choose which invoices you want to fund. (Full disclosure: FundThrough lets you pick which invoices to fund with no monthly funding obligation, no maximum, and no long-term commitment after the invoice is paid.)
- Factoring company verified customer relationship and invoice. The factoring company already determined they can work with the business. They now need to check that Target has accepted the invoice, and that the cookies from Sally’s company were delivered and accepted.
- Target is asked to sign an NOA. Having the customer owing the invoices sign a Notice of Assignment means they understand that the factoring company now owns the invoice and that they need to redirect future payments to them. While a lot of business owners get concerned about their customer being involved, many large companies are used to this process.
- The business owner gets funded. The business owner receives the cash in their bank account, typically less a 5% to 15% reserve. FundThrough has 100% rates so that you get all your capital at once. In our example, Sally now has peace of mind that she has working capital to take on the contract with Wal-Mart or cover any other cash flow gap. (This is our favorite part!)
- Target pays the factoring company according to the invoice terms. When Target pays their invoices, the factoring company will withhold their fees and pay the rest of the reserve back to Sally.
How Invoice Factoring Works at FundThrough
1. Create or connect your account in minutes.
Create a free account or connect your QuickBooks or OpenInvoice account, and provide information about your business.
2. Choose which invoices to fund.
Upload invoices into FundThrough or pull in eligible invoices from QuickBooks or OpenInvoice. We provide unlimited funding for your business based on the size of your outstanding invoices. Select which invoices you want to fund, and submit them in one click (after customer set up).
3. Get Funded.
Upon approval, funds are deposited into your business bank account as soon as the next business day. Put your capital to work for growth projects, payroll, equipment, hires, and more.
Ready to fund your invoices?
How Is Invoice Factoring Used?
The reason there’s a demand for invoice factoring is because of cash flow issues caused by long business-to-business (B2B) payment terms. In many industries, it’s not uncommon for standard payment terms to be anywhere from 30 to 120 days. Instead of business owners being paid right after they’ve delivered goods and/or services, they have to wait to receive customer payments.
This is a particularly difficult problem for small business owners who have large customers. They are excited to close a household-name customer for a large contract, but when they read the payment terms, they see that they won’t receive the money for months. This impacts their ability to maintain positive cash flow, not only making it difficult to run their business, but causing them anxiety. These small business owners need that money sooner rather than later to pay expenses, which can include:
- Making payroll
- Buying new equipment
- Paying their own suppliers
- Hiring staff
- Fulfilling large orders or projects
Growth is one of the most common uses for factoring
Those last two points are more common than you might think. With improved cash flow, many small businesses find themselves able to bid on projects that will require them to buy lots of materials or labor. Companies that had to turn down business due to a lack of cash can take on the extra volume. If this sounds like a stretch, just take a look at our customer stories. Run Veggie and Global Pipeline are two companies who are particularly direct examples of growing with invoice funding. (See more invoice factoring examples.)
To understand how they were able to get paid quickly, it’s helpful to understand some basic information about the process.
How Do I Qualify for Invoice Factoring?
In order to qualify for invoice factoring, there are several requirements that a business must meet. You must invoice other businesses and ensure you’re up-to-date on your business taxes (though many factoring companies work with businesses on payment plans with the IRS or CRA). Additional qualifications include having invoices for completed work to creditworthy clients, no liens on A/R you can’t get removed, and a few documents. These include your Articles of Incorporation, bank statements, and customer contracts.
Is Invoice Factoring Right For Me?
Invoice factoring can be right for your business depending on your situation:
- You have a timely opportunity for growth, like a large contract
- Net terms make payroll difficult
- You’ve reached your limit on a traditional line of credit
- You don’t have time to apply for bank financing and wait for a decision
- Your business is too new for banks to work with
- You need flexibility to get the amount funding you need, when you need it
If you’re trying to decide if factoring is right for you, it’s also important to consider the pros and cons below.
Advantages of Factoring Invoices
Small, growing businesses see multiple benefits of factoring, especially if they don’t want to be tied up with a bank loan. Here are a few benefits they typically see:
- Debt-free funding (not a loan!)
- Non-dilutive capital
- Save time without having to chase accounts receivable
- Easy qualification and application process compared to traditional financing
Advantages of Factoring Invoices with FundThrough
- Unlimited funding based on the size of your invoices
- 100% advance rates, minus a flat fee
- No hidden fees
- Flexibility to choose which invoices to fund and only get funding when needed
- An easy to use, tech powered platform that eliminates manual paperwork
- Integrations with QuickBooks Online and Enverus’ OpenInvoice
- Highly reviewed support team and a partner in your success
Ready to get funded?
Disadvantages of Factoring
Factoring has a few disadvantages compared to other financing methods, including:
- Higher interest rates compared to traditional loans or lines of credit
- The risk that your customer will think your business is not succeeding
- Potential damage to business reputation if factoring company is aggressive in collecting payment from your customers. (See how we work to maintain your relationships with customers if this worries you.)
- Hidden fees and charges that may not be immediately apparent in the initial quote
- Difficulty recording factoring transactions in bookkeeping. See our post with step-by-step instructions.
Get more info on invoice factoring advantages and disadvantages.
Master Your Cash Flow
Everything you need to master cash flow basics in a comprehensive guide and template.
Invoice Factoring Definition, Terms and FAQs
Why Is Invoice Factoring Useful?
Invoice factoring is useful boost to your business finances for a variety of reasons:
- Making payroll. This is one of the most common reasons to factor an invoice for quick cash. Important to note is that you can factor an invoice for any expense; it’s certainly not limited to payroll
- Funding growth. Many of our clients fund invoices so that they can pay upfront costs associated with landing a big contract or taking on more customers
- Increasing peace of mind. So many business owners worry about their cash flow. Having a funding option like factoring that’s always available ensures that they don’t have to worry about meeting their financial obligations. You also don’t have to worry about payment collection, as the factoring company works with your customer to redirect payment.
Can Invoice Factoring Save You Money?
Factoring can save you money if you’ve been extending early payment discounts that are greater than factoring fees or if you can get a bulk discount on materials in excess of the fees. It can also help you get more money in the long-term. If you have the cash to take on more business than if you’d waited for a customer to pay according to a 30, 60, or 90 day invoice payment term, you’ll grow your business and ultimately make more money. Our customer stories have many examples of how this works for all kinds of businesses.
When Should You Use Factoring?
Your company should consider using an invoice factoring solution if:
- Banks have turned you down for a business loan, credit card, or line of credit, or you don’t want to be tied up in traditional bank loans or lines of credit. It’s also worth considering if you already have bank financing, but they’ve denied raising your limit. Or if you can’t wait months to get approved.
- You need quick access to cash – in a few business days rather than a few months
- If you need a reliable source of funds for paying daily expenses and/or fueling growth
- You’re a startup company without much credit history yet. In many cases, an invoice factoring provider doesn’t require a credit check or high credit score because it relies on how credit worthy your customers are. Even those with bad credit or credit risk may qualify
- You want more time to focus on your business instead of chasing down late payments
Can Any Business Use Invoice Factoring?
It depends on the requirements of the factoring company. Many require you to have a certain length of time in business, minimum invoice volumes, or only work with particular industries. Additionally, each factoring company has it’s own procedures for evaluating credit risk and verifying the client’s customer and invoices. It’s important to look into these requirements to help you decide whether to use invoice factoring services or if you’re evaluating an invoice factoring agreement from a factoring firm. Be sure to also ask whether they require a service fee and about their advance rate (or the amount that’s typically paid to you up front. Some factoring companies for example will advance 80 percent of the invoice when they fund you and keep the remaining 20 percent until your customer pays. This is called the factoring reserve.) Some also require that you fund up to a certain minimum instead of letting you fund just a single invoice.
What Is Invoice Factoring & How Does It Work?
A factoring company purchases a business’s unpaid invoices at a discount, providing immediate cash. The company advances a percentage of the invoice total upfront (90 to 95 percent) and collects the full amount from the business’s customer. Once paid, the factoring company returns the remaining balance to the business, minus a service fee.
Accounts Receivable Factoring Definition
Accounts receivable factoring allows businesses to sell their unpaid invoices in exchange for quick access to cash. It is also known as invoice factoring or receivables financing. A growing number of small businesses are factoring invoices, as it provides them with immediate access to working capital. This funding is often used to cover cash flow shortages related to everyday expenses like payroll or purchasing supplies. Other business owners use factoring invoices as a way to get working capital they need to help grow their business.
Advance Rate Definition
The advance rate is the percentage of an invoice that a factoring company pays, or advances, to the business selling the invoice. Depending on the amount of the unpaid invoice, the industry, and the factoring firm, your advance rate will vary. When you fund an invoice with FundThrough, we’ll advance you the face value minus a small percentage as our fee. We do not charge any hidden fees like initial account setup fees, ACH fees, or processing fees.
Spot Factoring Definition
Spot factoring is a type of invoice factoring where businesses fund a specific invoice without entering into a long-term contract or relationship with the factoring firm. It is similar to selective factoring in that you can choose which invoice to factor, but unlike selective factoring there’s no ongoing relationship or expectation that you’ll continue doing business together after the funding cycle is complete. With FundThrough, you can pick and choose which invoices you want to fund, with no monthly funding requirements or limits to the funding you can get (as much as you have invoices for). Once the outstanding invoice is paid to FundThrough, there’s no further obligation.
Invoice Factoring Contract Definition
An invoice factoring contract is a written agreement between a business and an invoice factoring provider that outlines the terms of their funding agreement. Every factoring contract includes details such as invoice factoring fees, advance rates, service level agreements (SLAs), and how to terminate the agreement. It also clearly explains the rights and obligations of both parties.
What Qualities Should I Look For In A Factoring Company?
When it comes to choosing the best company for factoring invoices for your business, consider the following:
Experience. Not all factoring companies have experience with every industry. Sometimes it makes sense to work with a company that understands your business, so there’s less time spent explaining all the ins and outs specific to your industry and buyers. FundThrough has experience with small business factoring, oil and gas, trucking companies, raw materials providers, cross-border factoring, and many more B2B industries See the industries we serve here. (Even if yours isn’t listed, we still might be able to work with you.)
Flexibility. Any company factoring invoices will need to verify that they’re legit — that’s just par for the course. The best invoice factoring companies will offer flexibility in how they handle your business, listening to your unique needs. Additionally, you want a factoring business that lets you fund on your terms — no funding obligations, no maximums, and no long-term commitments once the invoice is paid.
Efficiency. Many factoring firms still use manual processes, which can be slow and expensive. The best factoring companies use technology and automation to make getting funded a seamless invoice process. FundThrough’s invoice finance platform boasts integrations with OpenInvoice and QuickBooks, which automatically pulls in eligible invoices so you can get funded in just a few clicks.
Transparent Fee Structure: Different factoring companies charge different funding rates, meaning the cost of invoice factoring varies. But not all companies are upfront about hidden fees – like initial account setups fees, service fees, or transaction fees – that can leave you with less funding than you planned for. See FundThrough’s pricing here.
Customer Service. Whoever you choose for factoring invoices should be invested in your success. At FundThrough, we offer dedicated account management, flexible solutions to get you funded, and treat your customer like our own.
What is Invoice Financing?
Invoice financing, like factoring, offers businesses quick cash through unpaid invoices. The crucial difference is the repayment responsibility. In invoice financing, it’s the business owner, not the customer, who repays the financing company. Business owners agree to a set repayment schedule, with service fees spread across payments. Meanwhile, customers continue to pay their invoices directly to the business owner as usual. Invoice financing provides prompt cash flow while preserving direct customer payment relationships.
Still unsure which method is right for you? Take a look at our detailed blog post where we explore how to choose between invoice factoring vs. invoice financing, helping you find the most suitable solution for your unique business needs.
How does invoice financing work?
In invoice financing, a financing company provides a business owner an advance on their invoices, typically up to 80% of the total invoice value, in return for interest and fees. This advance acts as an immediate cash infusion, facilitating smoother business operations. The remaining 20% serves as collateral until the invoice is fully paid.
The business owner then repays this advance according to a predetermined schedule, with the financing charges spread out over these repayments. This arrangement allows businesses to access needed funds quickly while efficiently managing their cash flow.
Is invoice financing the same as factoring?
No, invoice financing and factoring are not the same. While both methods provide immediate cash flow by leveraging your unpaid invoices, the key distinction lies in the repayment process. With invoice financing, the business owner is responsible for repaying the advanced funds to the financing company, whereas with invoice factoring, the business owner’s customer pays the factoring company directly, thus removing the repayment obligation from the business owner.
To better understand the nuances and differences between invoice financing and factoring, you may want to refer this blog post where we break it all down.
What are the benefits of invoice financing?
Invoice financing offers several distinct benefits, particularly when it comes to preserving customer relationships and providing a streamlined path to immediate funding. Key advantages include:
Preservation of Customer Relationships: The process keeps the customer uninvolved, ensuring no third-party intrusion into your business-customer relationship.
Speedy Approval: With no need for customer involvement, the approval process can often be faster than factoring.
Immediate Access to Capital: It facilitates fast and convenient access to working capital, ideal for solving common cash flow problems.
Efficient Process: The process is often smoother and quicker than traditional bank loans.
For a month in depth explanation, learn more here.
How do you qualify for invoice financing?
Qualifying for invoice financing can differ slightly from one provider to another, but the overall process tends to be fairly consistent across the board. Here are the general steps you’ll typically need to follow:
Documentation Submission: Initially, you must provide key documents about your business and the invoice you want financed. This includes business formation documents and a voided check for depositing the funds.
Invoice and Contract Review: You’ll need to supply the invoice you wish to finance and any related contracts. These documents help the factoring company assess the transaction, your customer’s creditworthiness, and the associated risk.
Credit Limit Establishment: After document approval, the factoring company sets your funding limit, which is the maximum dollar amount in invoices you can finance. This limit depends on your invoices’ value, your customers’ credit standing, and your payment history.
It’s important to note that these steps may vary among factoring companies. For a better understanding of their unique requirements and terms, directly contact the provider.
Is Invoice Factoring a Loan?
It’s understandable why some confusion might arise when discussing invoice factoring. Certain terms such as “invoice loan” or “invoice factoring loan” can muddy the waters and make it seem as if invoice factoring is a loan. This is not the case.
Invoice factoring is not a loan. In factoring, you’re advanced funds for work already done, and your customer pays the factoring company directly, making it a form of debt-free, non-dilutive financing. While on the surface, factoring and loans seem similar – both provide working capital that’s repaid – the repayment in factoring comes from the customer, not you. This confusion is exacerbated as “invoice financing” is sometimes used interchangeably with factoring. However, invoice financing is a different tool where the business owner repays the amount advanced against the invoice.
Not only is invoice factoring considered debt-free financing, it’s also non-dilutive funding — meaning you’re not giving up any equity in your business!
What Does Factoring an Invoice Mean?
It means that you get cash for unpaid invoices quickly, rather than having to wait on your customer to pay according to 30, 60, or 90 day payment terms that they dictate. In other words, you can turn unpaid invoices into cash.
Are There Different Kinds of Factoring?
In addition to factoring, another related funding solution is invoice financing. This is when a factoring company still gives a business owner cash for their invoice, but the business owner pays back the invoice amount themselves, plus a fee.
Wondering about how invoice discounting and invoice factoring are different? Invoice discounting is essentially a loan secured against your outstanding invoice, whereas invoice factoring involves an invoice factoring company purchasing the unpaid invoices outright.
Invoice Factoring Examples
Here are a few invoice factoring examples from real clients:
- Factoring for retail
- Factoring for construction
- Factoring for oil and gas service businesses
- Factoring for tech companies
See more on our customer stories page.
If you started this article unsure about what invoice factoring is, you now have a comprehensive explanation. Beyond the dry definition, it’s important to know what it isn’t, why business owners use factoring, and how it works at a high level. A solid understanding of the whole picture and process makes you fully informed about this financial tool and how it can make a difference not only for a business itself, but in the life of the business owner. If you have further questions about factoring, our Complete Invoice Factoring Guide has the answers.
We’ve found that when a business owner has steady cash flow, they’re freed from a huge hurdle keeping them from growth, and they no longer worry about having enough cash to keep their business running – even if they have enough money in accounts receivable. Having peace of mind about cash flow while being able to grow their business is why so many successful business owners take advantage of invoice factoring.