Invoice factoring is one way to free up more funds and boost a business' cash flow, yet a government survey shows that just 4% of SMEs used invoice factoring in 2019. As a small business owner, it's up to you to decide whether invoice factoring can help relieve the pressures on your cash flow.
Here, we explore the what invoice factoring is, what business types can benefit from it, as well as the pros and cons of this type of external financing.
What is invoice factoring?
Invoicing factoring is where a business raises money by selling a percentage of an invoices value to a third party (invoice factor). Invoice factoring can potentially unlock the value tied up in accounts receivables and release the working capital small businesses need.
Invoice factoring is a type of invoice finance, where a business raises money by selling a percentage of an unpaid invoice value, typically 70-90%, to a third-party company (invoice factor). Invoice factoring can release cash tied up in accounts receivables and release working capital.
Invoice factoring vs invoice discounting
An invoice factor takes over your debtor book, account receivables, your own credit control process and chases customers. In most cases, customers will know you're using a factor.
Whereas, an invoice discounter will also advance a percentage to you, but you manage and collect the invoice payments. Customers won't be aware the factor is involved.
How does invoice factoring work?
There are a number of UK factoring companies ranging from small invoice finance providers to large enterprises. Payment from an invoice factor is split into two phases – an advance on the invoice and once the invoice has been paid minus fees.
- Step 1: Eligibility - Check your eligibility with a debtor or factoring company. They will assess the risk and provide a quote. You may be required to provide your annual turnover as lenders may require a minimum turnover amount
- Step 2: Contract Agreement - Once you have reviewed and signed the invoice factoring agreement, the factor will provide the advance
- Step 3: Collection -: The factor will proceed with the collection of the outstanding invoice total with your customer
- Step 4: Final payment -: The factor will pay the remainder of the invoiced amount minus the fees once this has been collected from the customer invoices
Chinese pancake manufacturer Ming Foods has used both products since 2006 and has offered an example of how invoice factoring can help you with managing cash flow:
“Let’s say, for example, you want to take advantage of buying some stock before a price rise. You talk to your finance company and ask to advance more from invoices that have been sold to them; say from 75% to 85%," says CEO Sam Duong. "This releases instant cash flow for you to purchase at a discount or before the price rise. The finance company charges a small fee for the privilege and everybody wins in their own way.”
When to use invoice factoring
"Factoring can be very helpful to small businesses in particular, since factors have efficient collection procedures," says Michael Bickers, editor of the World Factoring Yearbook. "Also, finance is provided in line with sales so as a business grows, so does its funding."
Invoice factoring can potentially unlock the value tied up in accounts receivables and release the working capital small businesses need.
Invoice factoring could suit your business if...
- you invoice between 30-90 days.
- don't want a long-term debt.
- have high-value invoices that could impact cash flow if they're not paid on time.
- need money fast and can afford the factoring fees.
What are the costs of invoice factoring?
The costs of invoice factoring are different to loans as it is based on either a discount rate or service fee. This can differ based on the size of company and risk involved for the lending partner. The discount rate is typically 1% – 5% and fees occur during application and factor fee for each invoice fee processed.
The advantages of invoice factoring
Invoice factoring is a quick cash flow boost
Cash can be in your account in 24 hours – increasing your cash flow almost immediately because you are not waiting for a customer to pay.
“There’s always a high cost at the start of a business for all the equipment you need, and then you need to replace kit or buy new kit, so the cycle starts again," says Duong. "Invoice finance gave us access to the value of our invoices, helping us release working capital and grow our business through our sales.”
Invoice factoring frees up valuable time
Invoice factoring can free you from collecting debt, since you've outsourced the task to a financial company. This gives you back more time to focus on other aspect of the business instead, such as fulfilling orders, buying materials or expanding your business.
There's no collateral
Your invoices act as the collateral in invoice factoring, so there's no need to put up any of your real estate or equipment as collateral for the payment.
Disadvantages of invoice factoring
Not all companies can use invoice factoring
“Factoring is only suitable for businesses that sell to other businesses on credit, so businesses that sell to consumers, such as small shops, are not eligible," says Bickers. "Eligibility depends on volume as well. Generally, you need a turnover of £50,000 a year upwards.”
Providers take a percentage
Duong recommends small business owners to double check that they have the margins to support it before committing to the service. "If you are a low margin/high volume business, the extra 1-2% cost of invoice finance on your bottom line can make the difference between being profitable and not,” he says.
Factoring may not leave a good impression
Once you sell your invoices to a factoring company, legally, that asset belongs to them and they’re at liberty to chase your clients. If a client doesn't like the way the factor deals with them, you could risk losing their goodwill.
Getting out of it isn't always easy
If you want to terminate the agreement, and haven't reached the minimum annual fee, you’ll have to pay the difference. "Make sure you understand the power in these contracts and what the factor is allowed to do,” suggests Duong.
Invoice factoring or invoice discounting is just one of a few ways to help you manage cash flow. You can also improve your working capital by using an American Express® Business Card to pay for large items and keep your money in your account for longer, with up to 54 day payment terms¹ before the bill is due on purchases.
And that's not all. Your spending on the Card will earn you Membership Rewards® Points² that you can invest in equipment to help you grow your business.
- The maximum payment period on purchases is 54 calendar days on Gold & Platinum Business Charge Cards and 42 calendar days on the Basic Business Charge Card; it is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date.
- Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.