What is Invoice Factoring and How Does it Work?

Money on a tree

Invoice factoring is a business finance tool that gives organizations immediate access to the money that is owed to their business by their customers, without having to wait for 30, 60, 90 days or even longer, for the invoices to be paid.

Invoice factoring and invoice discounting are the two types of invoice finance. The main difference between them lies in who takes responsibility for collecting payment and control of the sales ledger:

1. With invoice factoring, the factoring company takes the role of managing the credit control, sales ledger, and chasing the customers for settlement of the invoices. While with invoice discounting, the business of the organization chases payments in the normal way and retains control of the organization’s sales ledger.

2. With invoice factoring, the customers settles their invoices directly with the factoring company; as a result they are likely to be aware of the organization’s or company’s factoring arrangement. While with invoice discounting, the customers still pay the organization directly; the customers do not need to know that a third party is involved.

Within invoice factoring there are two further options, these are with recourse and without recourse. Recourse is when the customers of the organization default on their payment and the organization becomes liable for the balance that is outstanding (this is the money the organization has borrowed from the factoring company). Nearly all invoice factoring companies insure their clients against this eventuality for an additional fee.

Invoice factoring enables expedited flow of cash, this means more options and flexibility for organizations when it comes to them reinvesting the working capital in their business and meeting their operational expenses.

How Invoice Factoring Works
1. A company provides services or products to a customer (this may be another company or organization) and the company then creates an invoice.
2. Instead of the company having to wait for several weeks or even months for their customer to pay, the company sells (or factors) the invoice to a factoring company and they can then immediately have access to their working capital.
3. The factoring company purchases (or factors) the invoice, and they then advance around 80% to 95% of the face value at a discount (or minimal fee), usually around 1% to 5% of the total of the invoice; the remaining balance is then held in reserve.
4. Once the customer remits the payment for the invoice to the factoring company, the reserve is released back to the company that provided the services or products to the customer.

 

Benefits of Invoice Factoring
It enables companies leverage their receivables in order for them to grow their business by factoring their invoices — turning the cash their customers owe them into money that is immediately available. Instead of companies waiting for several weeks (or sometimes even months) for invoices to be paid, they can receive money for factored accounts receivable invoices immediately,
this enables them to:
1. Have a competitive advantage by offering credit terms that are more appealing to their customers.
2. Replenish the flow of cash more quickly, this makes the management of their day to day expenses a lot easier.
3. Leverage their purchasing power to negotiate better terms with their vendors and suppliers.
4. Pursue bigger and new business opportunities and clients as a result of expedite flow of cash.
5. Reduce the resources and time that are needed for collection and accounting activities.
6. Reduce or may even eliminate the financial risk that may occur as a result of a bad debt by working with a non-recourse factor.

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