What Is Invoice Factoring?

Invoice factoring is an invoice finance facility that businesses use when they sell their outstanding invoices to a factoring company at a discounted rate. They get an advance on the money they’re owed whilst the lender takes over the credit collection process.

Invoice factoring, which is also referred to as debt factoring, is a specific type of invoice financing. This form of financing provides companies with instant cash injections in exchange for a service fee.

You receive up to 100% of your invoice value almost instantly, whilst the factoring company takes over the hassle of chasing your payments. Once your debtor pays the outstanding amount, the lender releases all remaining payments.

It avoids late payments and cash flow gaps – two influential factors to the survival of any business.

 

How does it work?

Invoice factoring works by selling your outstanding invoices to a factoring company, typically in exchange for a predetermined financing fee.

This fee is calculated as a percentage of your company’s gross turnover. One fee will usually cover all collection, administration, and management costs associated with the financing.

After processing your invoice and deducting the service charge, up to 100% of your invoice value is advanced and the lender proceeds to take over the payment collection process.

For example, if you’ve agreed on a 1% factoring fee and you issue your client an invoice for £10,000, the lender can advance you £9,900 as soon as your invoice is cleared.

This way you can benefit from the highest amount of capital in the shortest amount of time. You can then use this cash to pay contractors, pay your employees, or complete projects.

Invoice factoring vs invoice discounting

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Invoice factoring

Invoice factoring is not to be confused with invoice discounting, the two share some similarities but overall they are vastly different.

Businesses that opt for invoice factoring will supply individual debtors or entire sales ledger, and once these are approved, the lender will factor any outstanding invoices. Your business makes use of the cash it needs whilst the factoring company collects the payments from your debtors.

When you opt for invoice discounting, the financing process is the same, however, you are in charge of collecting the payment. It’s the most simple type of invoice finance because it’s just money and there are no services attached.

The main disparities between the two forms of financing are identified across the points of credit control, confidentiality, and costs.

Let’s take a closer look at the differences between invoice discounting and invoice factoring.

Invoice factoring allows the lender to have more control over the payment of outstanding invoices. The debt factoring company’s team of professionals manage collection of payment and release of funds. On the other hand, invoice discounting provides you with a more hands-on approach. You are in charge of ensuring your customers pay on time and correctly.

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Invoice discounting

Invoice discounting is a more discreet way to benefit from invoice financing. Since you’re in charge of collecting outstanding payments, your customers don’t need to know that you’re working with a factoring company. With invoice factoring, your customers know that you are using a finance facility because the debt factoring company interacts with them directly to retrieve the outstanding payments.

Since the invoice factoring company takes on the burden of this task, these additional services typically come attached to a higher service fee. Invoice discounting will be less expensive because you’re not paying to outsource your collections process. However, to qualify for invoice discounting, typically you will need to be an established business with a minimum turnover of £250k.

How does debt factoring improve cash flow?

Debt factoring can improve cash flow by advancing you a majority of your invoice value in a matter of days instead of weeks. You won’t have to sit around waiting for your clients to pay you, instead you can get on with other vital aspects of running a business.

A majority of small businesses in the UK have less than three months of cash reserves to sustain themselves. If you’re forced to wait months for several outstanding invoices, the survival of your business could be in jeopardy.

When you seek out financial assistance from banks, in the form of a loan or overdraft, it could take months before this is approved. Even if the bank does finally approve your financing, the funds could take a few weeks to materialise.

Invoice financing offers smaller businesses and startups the opportunity to receive financing whilst also offering enterprises of all sizes an excellent method to cover short-term cash flow problems.

 

Non-recourse vs recourse factoring

Within invoice factoring, there are two types of debt factoring, known as recourse and non-recourse factoring.

Non-recourse and recourse factoring refers to the process employed by the factoring company when a debtor abstains from paying their outstanding invoice.

Recourse factoring is the most common way to deal with a client that doesn’t pay their invoice. In this instance, you take full responsibility for the unpaid invoice and repay the cash that was advanced to you. This is more common because it is the least expensive way to deal with non-compliant clients.

A non-recourse agreement is when the factoring company assumes all of the risks. Although the lender assumes full responsibility, they also take on more risk and, therefore, non-recourse factoring fees are substantially higher.

Some factoring companies will only agree to non-recourse factoring and take responsibility for the unpaid invoice if a customer has declared bankruptcy.

The factoring fees between non-recourse and recourse factoring can often vary by as much as 1%. Therefore, it’s worth debating which is the right option for your business.

However, factoring companies have a team of dedicated professionals who will try to collect payments as quickly and efficiently as possible. A capable credit team won’t be willing to work with clients that have unfavourable payment histories.

 

What is reverse factoring?

Reverse factoring is when large corporations use financial institutions to bankroll their purchases in a quick and reliable way.

This method of financing, also known as supply chain finance, helps improve cash flow and reduce supply chain risk by helping buyers pay their suppliers quickly.

In brief terms, the factoring company acts as an intermediary and agrees to finance the buyer’s purchase in exchange for a fee.

This quick cash payment provided by the financing company helps buyers negotiate a discount and also helps suppliers accelerate their cash flow.

However, reverse factoring is only an option for large and established corporations with reputable trading histories.

 

Factoring and forfaiting

Invoice factoring refers to the sale of outstanding invoices to a debt factoring company at a discount for an immediate cash advance.

Forfaiting is when an exporter sells its claim of trade receivables to a foreifetar for an immediate cash payment.

Forfaiting is a form of export financing that is only used for international trade. Time frames for forfaiting can last several months or even years, making it substantially lengthier than factoring.

 

What are the costs of factoring?

Factoring costs can vary per company, however, they are typically calculated as a percentage of your gross turnover.

Some debt factoring companies will charge you a single fee that encompasses all costs associated with the factoring service.

However, other invoice factoring companies may try to add hidden charges, like startup fees, exit fees, or credit check fees. Therefore, it’s always important to read the fine print before entering an agreement with a debt factoring company.

There are many benefits associated with debt factoring, especially if you are a small business or startup.

What are the advantages of factoring?

Plug the cash flow gap

One of the most vital advantages of invoice factoring is plugging the cash flow gap of your business. Whether you need the money to take on new projects, pay contractors, hire new employees, or cover your overheads, a steady cash flow is vital.

Quick turnaround

In comparison to other, more traditional, forms of financing, invoice factoring has an incredibly quick turnaround. You can set up debt factoring in a matter of 24 hours and start receiving the cash your business needs.

Less risk

There’s not as much risk to your assets because your unpaid invoices act as collateral. You probably won’t be asked to put any valuable assets, like real estate or equipment, on the line when you use invoice financing.

Higher approval rates

Another advantage to debt factoring is that there are more chances of getting approved for financing. Banks demand a multitude of requirements in order to secure funding. Instead of examining your company’s credit history, invoice financing companies will focus more on the credit quality of your debtors.

No chasing

Outsourcing the task of credit collection is another of the advantages of invoice factoring. Small businesses or startups that don’t dispose of the time or resources to be chasing clients for their payments can benefit immensely from this service.

Customer credit

Factoring companies will only agree to finance invoices if the customer has a favourable credit history and they can even help you scope out potential clients. This can deter you from going into business with unreliable customers.

Improved relationships

Finally, invoice factoring could even help you improve your overall relationship with clients. More often than not, asking for money can be unpleasant or awkward but having a third party take over can relieve this pressure.

How do all-in-one invoice and back-office solutions work?

Invoice factoring with back-office support services allows businesses to work with financiers in a disclosed manner.

The invoice factoring company will collect payments on behalf of your business, using your company name, your logo, and your VAT numbers.

This service also comes with back-office functions that help support and manage the running of your different contractors.

FAQs

How does debt factoring work?

Debt factoring preserves the cash flow in a business by quickly financing unpaid invoices.

Instead of having to wait weeks, or even months, for your clients to pay their invoices, you can finance them with a factoring company.

Once you agree on a service fee, you pass on the invoice to the factoring company and this amount is advanced to you in a matter of days.

What are the different types of debt factoring?

Broadly speaking, debt factoring refers to the sale of unpaid invoices to a third party at a discounted rate in exchange for instant cash.

Debt factoring and invoice factoring are two terms that are used interchangeably. There are different three types of debt factoring available, more specifically, recourse factoring, non-recourse factoring, and undisclosed or confidential factoring.

If a business has agreed to recourse factoring, they become liable for any unpaid invoices that the factoring company could not collect payment for. In this instance, businesses must pay back the cash advance in full.

Non-recourse factoring is when the factoring company takes liability for the unpaid invoices that they could not collect payment for. However, non-recourse factoring is a more expensive and, therefore, a less common type of debt factoring.

Undisclosed, or confidential factoring, is the halfway point for businesses whose balance sheets aren’t strong enough to secure invoice discounting services. The company benefits from factoring services in a more discreet way as the debtor is unaware of the involvement of a third party.

What’s the impact of factoring on the balance sheet?

Cash flow management is an essential aspect of any company but even more so if you are a start-up or small business.

With a steady stream of revenue at your disposal, you no longer have to worry about paying your contractors on time. This reliable cash injection is especially useful if your company suffers from seasonal demands or lengthy payment collection times.

Debt factoring allows you to cover your expenses and helps fuel growth in a sustainable manner. This type of financing offers recruitment agencies a more flexible solution to short-term cash flow problems.

Is invoice factoring considered debt?

No, invoice factoring isn’t considered debt because you are selling your unpaid invoices to a third party at a discounted rate.

You’re not borrowing additional capital, you’re simply receiving the money you are already owed, ahead of time.

What’s the difference between factoring and credit insurance?

Credit insurance is a way to ensure that you receive your money even if your client declares bankruptcy.

Credit insurance will only pay out your unpaid invoices if the debtor cannot pay due to insolvency. It’s more of a guarantee against customer risk than a financing route.

Invoice factoring and credit insurance tend to go hand in hand. It’s a way for businesses to protect themselves against the risk of non-payment.

What happens if a client doesn’t pay an invoice?

Debt factoring companies will always try to avoid this scenario by managing accounts, vetting customers, and chasing after payments in the most effective way possible.

Nevertheless, if a client doesn’t pay an invoice, either you or the factoring company takes responsibility for the outstanding payment.

More often than not, businesses will opt for recourse factoring, which means your company buys back the unpaid invoice and takes on the responsibility for the non-payment.

If you have agreed to non-recourse factoring, your factoring company is liable for the risk and you are typically absolved of having to reimburse the unpaid invoice.

Sonovate offers its clients bad debt protection on 90% of their net invoice value. This means your cash flow can remain unaffected and healthy even if a debtor fails to finance their invoice.

For example, if you issue an invoice for £10,000, you will be protected for £9,000 of the debt. Typically, this bad debt protection is only available when client payment terms are less than 60 days.

How long does it take to set up invoice factoring?

Invoice factoring is relatively quick and easy to set up, especially in comparison to other forms of financing in the UK.

After your first appointment, your business could start using invoice financing services in as little as 24 hours.

Once your clients have been vetted and your financing has been approved, you can start receiving advances on your unpaid invoices almost immediately.

Is factoring suitable for startups?

Yes, invoice factoring is a great solution for startups that are beginning to establish themselves in their sector. To be eligible for invoice factoring, you must be a business invoicing other businesses with a minimum turnover of £50,000.

Startups may encounter some difficulties when it comes to securing a loan or overdraft from the bank. Traditional forms of financing demand a multitude of requirements, such as established trading records or high credit scores, whilst invoice factoring will focus more on the credit history of your clients.

Startups are always in need of liquidity and invoice factoring can provide this without the risk of incurring additional debt. Quick access to cash and an outsourced credit collection service gives startups the opportunity to focus on growing their business.

Finally, invoice factoring helps open the door for startups that want to start working with larger clients. If you only get paid at the end of the project, you may not have the working capital to start the job. Invoice financing can help you get an instant advance to the cash that you are owed and help fuel the growth of your business.

What checks are involved with factoring?

To benefit from invoice factoring services, you must be a business that works with other businesses, as invoices are only accepted on a B2B basis.

The checks on your own company are less extensive than the checks on the history of your clients. Your client must have reputable credit scores before an invoice factoring company agrees to finance their unpaid invoices.

Is debt factoring regulated?

No, debt factoring is not currently regulated by the Financial Conduct Authority (FCA) in the UK.

Since the invoice financing industry is unregulated, borrowers should ensure that lenders clearly state all of their fees and that their contracts outline clear termination clauses.

Nevertheless, the invoice factoring sector has enforced a clear code of conduct to provide the best possible service for customers.

Regulation of the invoice financing industry would incur regulation costs, which are typically passed on to the customers. This would then cause prices to rise and inhibit business owners from receiving the best financing deals.

What is credit factoring?

Invoice factoring is when a business sells its unpaid invoices, at a discount, to a factoring company in exchange for instant access to cash. However, when the buyer is purchasing the order with credit, this factoring is known as credit factoring.

This typically occurs when large retailers work with independent resellers that purchase orders with credit.  Whereas debt factoring is providing finance against the debt of the company, credit factoring is providing finance against the credit of a company.

What is payroll factoring?

Payroll factoring is another way to describe invoice factoring. It’s a method of financing that entails the sale of outstanding invoices, at a discount, to a factoring company in exchange for instant access to cash.

It’s referred to as payroll factoring because many times a business will struggle to pay its workers without a steady cash flow. Invoice factoring, or payroll factoring, provides a steady stream of revenue with the cash that you are already owed.

Can small businesses make use of factoring?

Yes, small businesses can benefit greatly from the use of invoice factoring.

A steady cash flow is essential for the survival of any small business and invoice factoring provides companies with the cash injections they need. Invoice factoring also takes over the credit collection process, which gives small businesses more time to focus on other things like growing the company.

Financing from banks, be it overdrafts or loans, demand many requirements, such as established trading records and high credit scores. Debt factoring doesn’t focus on your personal credit score but rather the credit history of your customers, making it much easier for small businesses to secure financing.

How is invoice factoring different from a business loan?

Invoice factoring is different from a loan because you aren’t accumulating more debt and you don’t need to fulfil a multitude of requirements. Traditional financing institutions will typically ask for more security and collateral than factoring companies.

Unlike business loans, invoice factoring doesn’t take your loan history or credit score into consideration, it only focuses on the payment history of your clients. This makes invoice factoring much easier for smaller and newly-established businesses to secure.

I’m a contractor, how do I benefit from factoring?

As a contractor, you benefit from invoice factoring because you can count on getting paid on time, every time.

Cash flow and liquidity can be an issue for many recruitment agencies. Invoice factoring lenders can advance recruitment agencies with the money they need to bankroll their contractors in a timely fashion.

Our Platform

Sonovate offers its customers a centralised system from which they can manage all invoice factoring services. All your business contacts can be managed in real-time with our easy-to-use app.

Our innovative invoice finance platform offers an easy solution for businesses to manage contracts, invoices, and timesheets. If you’re interested in learning more about the features and benefits of our services, don’t hesitate to book a consultation.

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