What Is Invoice Factoring? Advantages and Related Terms

By Indeed Editorial Team

Published August 11, 2021

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Maintaining a good cash flow in your business can ensure that you have the funds to pay your employees, purchase supplies, invest in new technology and maintain your business reputation. A business model that relies on invoices, however, may find challenges with maintaining cash flow since they provide services before their customers pay. One option to change cash flow is invoice factoring, which gets another company involved in collecting money from customers. In this article, we discuss what invoice factoring is, the different types of invoice factoring and some pros and cons of using it for your business.

What is invoice factoring?

Invoice factoring, also called debt factoring or accounts receivable factoring, refers to the process of selling some of your company's invoices to another company, who collects directly from your customers. It's usually used by companies who have invoices out to many customers, rather than companies who have just a few main customers. The precise relationship involved with invoice factoring depends on the companies and the accounts. Sometimes a company passes on all its invoices to the factoring company for a certain amount of time.

The process of invoice factoring starts after your business has performed its service or delivered its goods to a customer and issued an invoice. Your business enters an agreement with a factoring company, which buys some or all outstanding invoices and pays your company most of the value of those invoices. The factoring company collects the money from the customer. After the customer pays, the factoring company takes a fee out of that money and returns the remaining amount of money to the original business.

Related: What Does It Mean to Finance Accounts Receivable? (With Definition and Financing Types)

Advantages of invoice factoring

Here are some of the advantages of invoice factoring:

Better cash flow

Invoice factoring can improve your business's cash flow. The initial sale of invoices to a factoring company generates income right away in the amount decided by your agreement. An ongoing factoring company relationship may also provide predictable income rather than the sometimes unpredictable results of your own accounting department attempting to collect. This predictability can help you make financial plans and investments.

Read more: Guide to Cash Flow

Less billing overhead

Depending on your system for billing and collecting from your customers, invoice factoring may require less overhead. It's essentially outsourcing collection duties, so you may be able to have a smaller billing department. This can provide savings on hiring, payroll and benefits.

Quick income generation

Invoice factoring allows your business to have some of the money from sales before the customer pays. If your business is struggling, invoice factoring may provide a quick injection of cash to help you get income to pay bills and continue work. Cash flow is vital to remaining profitable, so invoice factoring may be a valuable resource for your business if you're struggling to collect. It can also be a way to generate income without having to invest money in hiring more people for your billing department.

More convenient than a bank loan

Bank loans usually require extensive documentation and application processes, while invoice factoring is a relatively straightforward business agreement. Factoring companies earn a profit from the invoice factoring as soon as they take fees from you and collect the money, so they may be more eager to pay you for the invoices than a bank would be to take a risk on your profitability. If you need to improve your cash flow quickly, factoring may also be more efficient than a bank loan.

Related: How To Calculate Accounts Receivable and Related Formulas

Disadvantages of invoice factoring

Here are some disadvantages of invoice factoring:

Commitment

Invoice factoring commitments depend on the company, and many companies want a commitment to pass on your invoice factoring to them for a certain amount of time. Sometimes this can be years, so it's important to make sure of your decision before agreeing with an invoice factoring company. Invoice factoring companies may also want to take over a large portion or all of your invoices at once.

Variable cost

The cost structure for an invoice factoring agreement may vary depending on your customers. If your customers have poor credit, the factoring company may charge more in fees. They may also return invoices to your company for customers who still don't pay.

Passes on relationship with customers

When an invoice factoring company purchases your invoices, they start to interact with your customers to collect on those accounts receivable. This means they communicate directly with your customers, so they're taking over partial customer service for you, and poor interactions with a factoring company may change how customers feel about your business. The use of a factoring company can also change customers' impression of how well your business is doing since it sometimes indicates that a company is struggling with cash flow.

Related: How To Get Clients To Pay You (With Tips)

Types of invoice factoring

Invoice factoring agreements depend on the companies involved, what their priorities are and what resources they have. Here are some variations and types of invoice factoring:

  • Selective factoring: This is an arrangement where a company sells some but not all or even most of their invoices to a factoring company. Spot factoring is a more narrow version of selective factoring.

  • Confidential factoring: This is invoice factoring where the customer doesn't know they're interacting with a factoring company, which may help preserve the customer image of the company.

  • Disclosed factoring: Disclosed factoring is the opposite of confidential factoring and a more typical arrangement, where the customer understands they're communicating with the factoring company rather than the original firm.

  • Recourse factoring: A common arrangement where, if the factoring company can't collect on an invoice, they pass it back to the original company, which must pay back the money for that invoice.

  • Non-recourse factoring: An arrangement where the factoring company doesn't pass bad debts, or invoices that can't be collected, back to the original company. Fees may be higher for this since the factoring company risks those undeliverable invoices.

  • CHOCC factoring: This is an abbreviation for client handles own credit control factoring, and it means that the original company still tries to get paid for their invoices, even after they've sold them to a factoring company.

Important terms related to invoice factoring

Here are some frequently used terms that relate to aspects or types of invoice factoring:

  • Accounts receivable: A company's accounts receivable is the amount of money that their customers owe them. If their accounts receivable are large in proportion to their cash flow, they may have trouble paying for supplies, payroll and other expenses.

  • Cash flow: Cash flow is the amount of money that a company is spending or earning during a given time period. If it's positive, the company is making a profit; if it's negative, the company is losing money.

  • Credit control: This is the process of making sure that customers pay a company what they owe, including reminding them of their obligations.

  • Payment terms: This refers to the amount of time a customer has to pay after they receive their invoice.

  • Disbursement: This is the collection of additional fees or expenses that a factoring company charges to handle invoices.

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