What is Invoice Factoring and How Does it Work?

What Is Invoice Factoring?

Invoice factoring is a type of invoice finance where a company sells its outstanding invoices to a third party as a way of improving its cash flow.

A factoring company pays most of the invoiced amount immediately and collects payment directly from the other company’s customers.

Invoice factoring is also referred to as accounts receivable factoring or debt factoring. The article will cover the advantages and disadvantages of invoice factoring.

How Does Factoring Work?

Invoice factoring involves a company selling control of the accounts receivable, either in full or partially.  This is how it works:

1. A company providing goods and services to its customers in a normal way.
2. The company invoices its customers the goods and services.
3. The company sells the raised invoices to a factoring company. The factoring company pays the bulk of the invoiced amount immediately, up to 80-90% of the value, after verifying that the invoices are valid.
4. The customers pay the factoring company directly. If necessary, the factoring company chases invoice payment.
5. Once the factoring company has been paid in full, they pay the remaining invoice amount minus their fee.

When Should a Company Consider Factoring?

A company should use invoice factoring when there are a lot of outstanding invoices and its cash flow is suffering because of it. Invoice factoring allows the release of the cash and the money could be used to

1. Repay loans
2. Take advantage of seasonal business opportunities
3. Bridge short-term expenses

What are the Advantages of Factoring?

There Is A Better Chance Of The Company Or Business Surviving

A good cash flow gives a business a chance of survival if used well.

The Cash Flow Becomes More Predictable

In invoice factoring, the bulk of a company’s invoices are paid almost immediately instead of waiting for the money to come in. Therefore, business forecasting is more accurate.

It Is Cheaper And Easier Than A Bank Loan

It is easier and cheaper to obtain, making it good for short-term funding needs.

It Reduces The Business Overheads

While there are fees associated with invoice factoring, they may be lesser than credit control staff. It also improves the morale of those working in the accounts department as they do not have to chase payments.

With the advantages, there are also disadvantages.

Disadvantages of Invoice Factoring

Can Harm The Company’s Relationships With Customers

When the factoring company is handling credit control, they also have control of the other company’s clients.

It Is Unsuitable For Businesses With Few Customers.

Factoring companies prefer spreading their risk as widely as possible.

It Requires A Big Commitment

Most factoring companies want to take over the bulk of accounts receivable as possible. This means that a company should have lots of customers.

Extra Costs If It Fails

If customers turn out to be worse payers, the company will have to pay extra disbursements.

A company’s commitment is required for it to work.