Invoice factoring is a form of debtor finance during which a business sells invoices or accounts receivable to a 3rd party at a discount. Companies can use invoice factoring to enhance their working capital and attain immediate funds which will be utilized to pay for company costs. It’s a financial transaction and form of invoice financing. It aims to scale back credit risk for borrowers.See Your Options
You may also refer Factoring as accounts receivable factoring, invoice factoring, and sometimes erroneously accounts receivable financing. Accounts receivable financing is a form of asset-based lending (ABL) utilizing a company’s accounts receivable as collateral.
The amount of finance available will typically be stated as a percentage of your outstanding debtor book or sales ledger but could also be constrained by specific terms such as limiting exposure to a single large customer.
Typically, payments from your customers will go into a bank account controlled by the factoring company, and your customers will be aware that you are using factoring. Some factoring providers will offer you the choice to credit insure particular customers or your entire sales ledger to attenuate your exposure to bad debt (this is also understood as recourse and non-recourse factoring).
Joe’s Business needs help with funds and agrees to a factoring facility with a lender. The advance percentage in Joe’s agreement with The Invoice Company is 80%, so when Joe raises an invoice worth $10,000 and uploads it online, The Invoice Company advances Joe $8,000.
As we’ve talked about, one potential advantage of factoring is credit control, so if the customer was late paying what they owed Joe, The Invoice Company would contact them on his behalf and remind them the bill was overdue. In extreme cases, lenders will even take legal action if necessary — these sorts of credit control services are a key advantage of factoring.
When the customer has paid, the cash goes to The Invoice Company, and then Joe receives the remaining invoice value minus the Invoice Company’s fees. In this example, Joe would typically pay about $400 in fees, so he’d get around $1,600 once the customer paid. Joe’s customer would also know he was exercising a factoring provider.
Factoring is a subcategory of invoice finance. Other sorts of invoice finance are invoice discounting, where you remain responsible of your credit control, and selective invoice finance, where you will choose which customers or invoices to finance. Businesses with slow paying invoices use factoring as a helpful form of invoicing to advance their cash flow. Why? Because it’s fast, interest-free, and an easy alternative to taking out a traditional bank loan.
Companies don’t need to borrow capital or take out a new line of credit. Instead, they can get an early receipt of their outstanding payment. It’s versatile because it depends entirely on the number of invoices that are sent out per month. So, a company’s access to funds scales with their business. Typically, an invoice factoring company buys the accounts receivable of the clients, and therefore the purchase enables the client to access immediate funds for business expenses.
Recourse & non-recourse
Factoring is predicated on the cash owed to your business in the form of invoices — but what happens if a customer doesn’t pay?
Recourse factoring is the most common which means that your company must buy back any invoices that the factoring company is unable to collect payment on. You are ultimately liable for any non-payment.
Non-recourse factoring means the factoring company assumes most of the risk of non-payment by your customers. Non-recourse doesn’t necessarily protect your company from all risk, though. There are usually stipulations related to non-recourse factoring, and the situations during which you are not liable for customer non-payment are very specific.