Invoice factoring: The complete guide

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Page written by Michael David. Last reviewed on October 2, 2024. Next review due April 6, 2025.

If you want to smooth out your business cash flow, invoice factoring is a solution to consider. It can be one of the quickest ways to receive an injection of cash when you need it. Here’s what you need to know.

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What is invoice factoring?

Many businesses find themselves in the position of having invoices that are owed to them but not enough cash in the bank when they need it. Invoice factoring refers to selling those unpaid invoices to a factoring company that provides you with cash immediately. You can think of invoice factoring as a cash advance for your businesses.

How does invoice factoring work?

Invoice factoring has similarities to a short-term business loan, but it is really its own unique process. Here’s how it typically works:

You get approved by a factoring company. They will want to understand your business and the creditworthiness of your clients so they feel comfortable providing you with cash advances against future invoices. You will sign a contract that allows you to begin your working relationship.
You send your invoices to your client and the factoring company. This will let the factoring company know when you are owed money so they can prepare to pay you in advance.
You receive an advance from the factoring company. The amount of funds you receive will depend on the terms of the contract, but it is typically 70% to 90% of the value of the invoice.
Your client pays the factoring company and the factoring company pays you. Your clients will send their payment to the factoring company who will deduct their fee and pass the remainder on to you.

Example invoice factoring scenario

Terry owns a property maintenance business and just billed a client for £20,000. He submits a copy of the invoice to his factoring company and they send him a £16,000 payment immediately, which is equal to 80% of the invoice. When the factoring company receives payment from the client a few weeks later, it deducts a 2% factoring fee, which works out to £400, and passes the remaining £3,600 to Terry.

In short, Terry agreed to be paid a total of £19,600 instead of £20,000 in exchange for receiving most of his money right away, which helped him pay the crew who worked on the job.

Why do companies use invoice factoring?

Managing cash flow is one of the greatest challenges of any business. Balancing the amount and timing of money coming in and money going out can be a constant challenge, and invoice factoring can help. Businesses choose this form of financing for several reasons, including:

Cash flow management. Being able to access money that is owed to you quickly allows you to stay ahead of expenses and invest in growth opportunities.
Easy to qualify. The factoring company is mainly looking at your clients’ ability to pay, not the creditworthiness of you or your business. This is especially favorable if your clients are well-established.
Collateral not required. Invoice factoring is secured by the invoices owed to you, not by your property, equipment, or personal credit.
Fast and simple. Unlike most bank loans, invoice factoring does not involve a long or complex application process. Once you’re set up, you can expect to receive cash advances quickly.

When it comes to how the funds can be used, just think of all the potential applications for invoice factoring in your own business, such as:

Making payroll
Hiring new staff
Paying for advertising and marketing
Covering rent and other overhead
Placing inventory orders
Buying raw materials
Investing in vehicles or equipment

Invoice factoring can be a way to access funds more quickly for just about any capital requirement you have in your business.

How to qualify for invoice factoring

If you run a business that sends out invoices, as opposed to ringing up sales at a cash register, then you have a chance to apply for invoice factoring. Here are some of the things an invoice factoring company will look for:

Billing history. If you can show a consistent history of invoicing companies that pay you on time, you have a good chance of qualifying. The factoring company will likely request an accounts receivable aging report so they can see how quickly your clients are paying you.
Healthy credit. Although the invoice factoring company is primarily concerned about your clients’ ability to pay, it can reduce their risk if you have a good credit score too.
Solid revenue. The factoring company may have a minimum monthly revenue requirement, and may choose which clients can count towards meeting it.
Track record. Your length of time in business not only allows you to show a more established billing history, it also tells the factoring company that you are more likely to remain viable into the future.

What are the advantages and disadvantages of invoice factoring?

Most business decisions involve trade-offs, and invoice factoring is no exception. Here’s a look at some of the pros and cons of invoice factoring.

Advantages of invoice factoring:

Improve cash flow by receiving payment for invoices much more quickly — sometimes even the same day.
Save time that you might currently be spending following up with clients about unpaid invoices.
Qualify for funding more easily than with a conventional loan, as the creditworthiness of your clients is the main concern.
Potentially reduce risk, as some factoring agreements are non-recourse, which means the factoring company takes the loss if your client never pays their invoice.

Disadvantages of invoice factoring:

Lower profit margins as a result of paying factoring fees.
Hidden costs if the factoring company adds fees for things like setting up your account, handling transactions, or failing to achieve minimum revenue requirements.
Reputational risk if the factoring company fails to deal with your clients in a professional manner.
Financial risk if the factoring company operates in an unethical manner, which has sometimes been a problem in the factoring industry (do your homework before you sign with any factoring company).

What alternatives are there for invoice factoring?

One of the main alternatives to invoice factoring is called invoice financing. With invoice financing, you do not outsource the collection of your invoices to anyone else. Instead, you use your outstanding invoices as collateral for a secured loan. When you collect your invoices, you can repay the loan. Here are several other alternatives the invoice financing that you may wish to consider.

Short-term business loan

Compared to invoice factoring, a short-term business loan can be more difficult and time-consuming to obtain, but it offers you a lump sum of capital and the cost of borrowing is usually lower. You’ll be responsible for repaying the loan through regular instalments over a period of months or years.

Business credit cards

Like invoice factoring, a business credit card can put spending power in your hand very quickly. However, they usually come with a high cost of borrowing and since you are only required to make a small minimum payment each month, it takes discipline to keep the balance under control.

Business line of credit

A business line of credit is similar to a credit card in that it is “revolving” credit — meaning you are not required to pay it back in a fixed timeframe. However, if you are able to qualify, the cost of borrowing on a business line of credit is usually much lower than that of a credit card or invoice factoring.

Merchant cash advance

A merchant cash advance has a lot in common with invoice factoring, but is generally designed for retail shops that do business at the cash register. You can receive a cash advance in exchange for a percentage of your credit card receipts until the loan is repaid with fees. Beware that these fees are typically quite high.

Small business grants

If you can find a small business grant offered by a government body or not-for-profit organisation, you win because these amounts never have to be repaid. However, they can be hard to find, difficult to apply for, and unlikely to come along at the exact time you need the money — which is the main advantage of invoice factoring.

How to choose the best invoice factoring companies

When you’re looking for an invoice factoring partner, there are a number of questions to ask:

What’s their reputation? Hop online and search any company you are considering working with. Check the reviews and cross out any companies with serious red flags.
How fast are they? Some companies use online portals and wire transfers to put money in your hands a lot quicker than others.
What are the minimums? The requirements can vary, and you might not qualify or might have to pay extra fees if your monthly billing doesn’t pass a certain threshold.
Do they know your industry? If so, not only might they speak your language, they might also better understand the patterns of your revenue and the quality of your clients.
How does the money work? Make sure to understand the advance rate (what percentage do you get up front?), the discount rate (what percentage do they keep in fees?) and the recourse policy (do they cover bad debts or do you?).
What are the contract terms? Know whether you will be “spot” factoring, which means assigning one invoice at a time, or “contract” factoring, meaning you sign a contract to process a specific volume of your invoices with the factor.

What is the average cost of invoice factoring?

When you work with a factoring company, the fees are usually affected by two main variables, and you have the opportunity to shop around and negotiate for each of them:

The factoring fee or discount rate is the percentage of the invoice value that the factoring will keep in exchange for their services. This can range from as low as 2% to as high as 10%. Generally, the more creditworthy your clients and the higher the volume of invoicing you do, the lower this fee will be.
The factoring period is not a fee, but it is a variable that can affect the total cost of factoring. The longer an invoice remains unpaid, the higher the factor fee or discount rate may be. Therefore, it’s important to set a factoring period that will allow your clients to pay their invoices in time.

There are also a range of other fees that you could be levied, from administration and account fees to overdue balance and even unused line fees. Make sure to see the whole list of fees before you decide on which factoring company to work with.

Are factored receivables subject to taxes?

Whether or not your factored receivables are subject to tax can be difficult to determine, so our advice is to consult a tax professional with expertise in this area.

HMCR will review your situation in an effort to ensure that there is no attempt to use invoice factoring to transfer income overseas or engage in tax evasion or tax avoidance. They may consider where the factoring company is located (offshore locations could be cause for concern), your relationship with the factoring company, the type of factoring agreement you use, and whether or not you are treating the costs of factoring as tax deductions.

To avoid problems, it is recommended to be consistent and transparent with your reporting around your factoring activity.

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Written by

Michael David

Michael David is a financial writer and former investment advisor. Writing for Capital Group, Dimensional Fund Advisors, Franklin Templeton Investments, HSBC, Invesco, PIMCO, Vanguard, global insurance companies, major banks and others, he has educated professionals, business owners and consumers about strategies for investing, insurance, banking and corporate finance for more than 20 years.

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