Invoice Factoring Guide: Factoring Your Accounts Receivable

Invoice Factoring Guide: Factoring Your Accounts Receivable

Invoice factoring is a method of business financing in which a company sells or assigns its invoices to a factoring company at a discount in exchange for immediate cash. Invoice Financing improves cash flow because the company doesn’t have to wait 30, 45, 60 days or more for the collection of its accounts receivables.

Invoice factoring is commonly referred to as:

  • Accounts receivable factoring
  • Accounts receivables financing
  • Invoice financing
  • Invoice discounting

Factoring is not a loan. It doesn’t create debt or require you to make loan payments. Invoice factoring is not bad debt collections. Factoring companies don’t purchase past-due receivables. They may purchase receivables that become past-due, but factoring companies don’t initially buy past-due or “seasoned” receivables. They purchase your existing receivables when you factor your very first batch of invoices (if you want) and then purchase your subsequent “fresh” or new invoices.

Factoring companies perform three basic steps:

  1. Buy your invoices and send funds (invoice amount less a reserve) immediately to you.
  2. Collect your receivables from your customers.
  3. Remit the reserve to you as final payment.

Most factoring companies don’t require you to factor all your invoices. They usually allow you to select only the customers that you want to factor. This gives you some flexibility on how much you want to factor and which customers you want to factor. A few factoring companies require you to factor all your invoices. All our listings on FactoringClub tell you if they require you to factor all your invoices.

Is Invoice Factoring Right For You?


We’ve put together a fun game of Flip-IT to help you determine whether invoice financing is right for your business. Click on the questions below to “flip” the box and see the answers. Discover answers to questions regarding poor credit, factoring costs, business conditions for factoring, and different uses of factoring funds.

Poor Credit

Can I qualify for invoice factoring if I have poor personal credit?

Should I Factor?

Yes... don't let poor credit stop you. Factoring companies focus more on your customers' credit.

Factoring Cost

Is invoice factoring too expensive for my business?

Should I Factor?

If the use of factoring generates more profit than it costs, then factoring is a good financial decision.

Growing Business

Is invoice factoring the right financial strategy to fund my growing business?

Should I Factor?

Factoring is an excellent financing tool for growing businesses, especially if you don't qualify for a traditional line of credit.

Seasonal Sales

Should I use invoice factoring to fund inventory or production costs resulting from seasonal spikes in sales?

Should I Factor?

Yes... factoring is an excellent financial tool for smoothing out seasonality in sales.

Debt Retirement

Should I use invoice factoring to pay off long-term debt or tax liens?

Should I Factor?

Cautiously... use only the profits of your business without impairing working capital. For large debts, set up an affordable installment plan.

Equipment Financing

Should I use invoice factoring to pay for equipment purchases?

Should I Factor?

Cautiously... use only the profits of your business without impairing working capital. For expensive equipment, you should get an equipment-based installment loan.

Invoice Financing vs Bank Loans

So your business needs cash for some reason… rather than borrow from a bank, you decide to factor your receivables. Reasons to select invoice financing versus bank loans include the following:

  • Your business doesn’t qualify for bank financing.
  • Your business can’t get adequate bank financing.
  • You can’t afford 2 or 3 months to wait for a bank approval.

Accounts receivable financing can be as effective as a bank line of credit. Certainly, it’s better than a traditional term loan for businesses seeking working capital financing. In fact, factoring has the added benefit of managing itself as a working capital line of credit, as long as you spend the funds on business operating expenses, rather than expensive equipment, large debt payments or vacations.

The Accounts Receivable Factoring Process


Accounts Receivable Factoring Diagram

Accounts receivable factoring generally occurs in six sequential steps. It begins with the completion of selling your product or service to the final step of receiving your final payment. Factoring companies may vary on whether they collect their factoring fees on the “front-end” or “back-end”. Front-end fees are paid below in step four. Back-end fees are paid at final payment in step six.

The Accounts Receivable Factoring Process Step-by-Step

Here’s a look at the entire accounts receivable factoring process:

  1. Your business completes a sale or service to your customer.
  2. You generate your invoices and provide a list of the invoices to your factoring company on a Schedule of Accounts or Assignment Sheet.
  3. The factoring company verifies the sale or service was performed, then forwards the invoices to your customer(s).
  4. The factoring company wires funds to your bank account, usually within 24 to 48 hours. They fund the invoice amount based on an advance rate. If the advance rate is 85% then the factoring company will send you 85% of the invoice and hold-back a reserve of 15% for possible bad debts.
  5. The factoring company collects the receivables and deducts charge-backs and factoring fees from the reserve.
  6. The factoring company sends you the available reserve as final payment.

This entire process is repeated for each invoice or batch of invoices that you factor. At any time during your business cycle, you may have multiple invoices in various stages of the process. For instance, you will probably submit new invoices while other invoices are still being collected. At any time, you may request or have online access to accounts receivable reports from your factoring company that shows the invoices outstanding, invoices paid, as well as invoices past-due. These reports are a large part of the overall services that factoring companies provide to you.

How Factoring Receivables Improves Cash Flow


Accounts Receivable Factoring Cash Flow Diagram

Let’s face it, the main reason businesses are factoring receivables is to increase their cash flow. Faster collections translates into more cash on hand to operate your business. Financial professionals call this the business cash cycle. It’s technical speak for how quickly (or slowly) cash is cycling through your operations. The faster you can generate cash from your receivables, the shorter and quicker your cash cycle and the more working capital you have.

Business Cash Cycle

Successful businesses learn to manage cash flow, so let’s look at the cash cycle of a business:

  1. You purchase raw materials (or pay employees) and convert them to finished products (or services).
  2. You sell those products (or services) and extend credit to your customers.
  3. You collect the receivables from customers.

This is called the cash cycle – the amount of time your cash is tied up in working capital (inventory, payroll and accounts receivables). The largest component of your cash cycle is your outstanding accounts receivable. Accounts receivable factoring eliminates days outstanding and improves cash flow.

You can easily see why the collection period is a major component of your cash flow. Cash tied up in accounts receivable can drain your cash and ultimately harm your ability to operate your business. This is why factoring receivables is so effective for businesses that need cash. It puts cash in your pocket, not in your customers’ bank account so you can use it for operating expenses such as payroll costs, inventory or overhead costs.

“If you got paid for sales the instant you made them, you would never have a cash flow problem.”

– Entrepreneur.com

Accounts Receivable Financing Benefits


Obviously, cash flow is the main benefit of accounts receivable financing, but there are many other incidental benefits too. Quickness and ease of approval, receivables management, credit services and invoice verification are a few of them. Small businesses that have relatively few employees benefit the most from receivables financing. They can focus on business operations and strategic objectives rather than hassling with paperwork, billing and collections and other accounting duties.

Quickness and Ease of Approval

More than anything else, quickness and the ease of approval make receivable financing so attractive. In an age of slow-moving and tight regulatory qualifications for bank loans, factoring provides small business quick access to immediate cash without all the fuss. It just works. If you’ve ever applied for a bank term loan or line of credit, you know how invoice factoring makes life much easier. Banks can take up to many weeks or even months to accept or reject your 10 page application. Your business suffers without even knowing whether or not you’ll qualify. Yet, accounts receivable financing only takes days or a couple weeks to get started.

Receivables Management

Virtually all factoring companies provide accounts receivable reports for your business. Many factoring companies offer a 24/7 online portal so you can view your current paid and unpaid accounts in real-time. You can see which customers are paying late and those that are paying on-time. You can check your available reserve amount that you have waiting for final receipt of payment. All the accounts receivable functions including accounting, collections and reporting are usually done by the factoring company. In fact, factoring your receivables can often pay for itself in time spent handling all your accounts receivable billing, collections, accounting and reporting.

Credit Services

Most factoring companies provide credit services. When you submit your business factoring application, the factoring company usually runs a credit check (via Dun & Bradstreet or a similar credit bureau) on the customers you want to factor. Factoring companies analyze your customers’ credit scores to determine the likelihood of your invoices getting paid, as well as maximum credit limits so you don’t get over-extended with a customer. Sometimes factoring companies reduce credit risk by purchasing trade credit insurance for your receivables. Credit insurance may be appropriate if you have a customer with financial issues or if you have a high concentration of sales with a single customer. It may also be standard practice for non-recourse factoring agreements to protect the factoring company. All these credit measures and practices protect both you and the factoring company from potential bad debt losses.

Invoice Verification

Invoice verification is a valuable service that factoring companies perform to insure that your invoices are sufficiently documented so they get paid. Inaccurate or insufficient invoice documentation can result in time consuming delays, interrupted work flow, and even non-payment issues. Without invoice factoring, just one erroneous invoice could cost you the money to pay for factoring services. Factoring gives you more time to focus on your business, not billing details.

Internal Control

You would be surprised how much fraud occurs in small businesses every year. According to this article in Entrepreneur.com, almost half of businesses experience fraud at some point in their life cycle. Cash receipts and accounts receivable are high risk areas for employee fraud and embezzlement. Many small businesses don’t have enough people to adequately separate the different cash functions to prevent employee theft. Invoice factoring provides internal control measures by having your factoring company control handle some of these functions. Nobody suspects their employees would take money from the company. However, many business owners have been bankrupted by fraud and embezzlement.

Invoice Factoring Rates

Factoring rates are very specific to each business. This is why FactoringClub doesn’t quote rates in our factoring company listings. Factoring rates depend on various criteria such as sales volume, industry risk, customer risk and overall company stability. Rates can vary anywhere from 1% all the way up to 8% or more depending on the weight of these criteria. To get a good estimate of your factoring costs, try our factoring calculators. This will help you get an idea of what rate structure you should get. Most factoring rates are either flat rates or periodic rates.

SALES VOLUME

Higher Volume - Lower Rate

The higher your sales volume, the lower your invoice factoring rate. Factoring $500,000 sales per month has a lower rate than factoring $50,000 per month.

INDUSTRY RISK

Higher Risk - HIgher Rate

Some industries such as construction and medical receivables carry more risk. This is mainly due to the higher risk associated with their payment methods.

CUSTOMER CREDIT

Higher Credit - Lower Rate

The better your customers’ credit, the lower your invoice factoring rate. Factoring companies use your customers’ credit scores to determine your customers’ risk.

COMPANY STABILITY

Higher Stability - Lower Rate

Factoring companies look at the stability of your business, as well as the owners. They take into account overall profitability of the business and the character and integrity of its owners.

How to Determine Your Factoring Cost

Let’s look at a few cost scenarios so you can get an idea of invoice factoring costs. Let’s say your business needs to factor $100,000 of invoices with expected days outstanding of 45 days.

Scenario A: Factoring Company A charges a flat rate.

  • Factoring Rate: Flat rate of 3.5% on your invoices.
  • Factoring Cost: $3,500
  • Effective Rate: 3.5%

Scenario B: Factoring Company B charges a monthly rate (pro-rated).

  • Factoring Rate: Monthly rate of 2.0% on your invoices.
  • Factoring Cost: $3,000
  • Effective Rate: 3.0%

Scenario C: Factoring Company C charges a weekly rate (not pro-rated).

  • Factoring Rate: Weekly rate of 0.8% on your invoices.
  • Factoring Cost: $5,600
  • Effective Rate: 5.6%

As you can see, there is a very large variation in cost depending on the rate structure. The costs for factoring companies A and B are comparable, except that the flat rate in Scenario A is going to protect you if your collection days exceed the expected 45 days. Company A or Company B are your best choices depending on your days outstanding. Avoid Company C under all circumstances!

The Business Factoring Agreement Process


All business factoring agreements follow the same process. First, you complete the application and submit the necessary documents for the factoring company. Second, the factoring company performs underwriting (a big word for homework) to determine your qualifications for factoring. Third, you actually sign the factoring agreement and related documents.

The entire process can take anywhere from a day to two weeks, depending on the factoring company’s ability to do their “homework”, as well as the difficulty of your particular business situation. A normal approval process takes approximately 3 to 5 working days.

1. Application and related documentation:

  • The application form.
  • A report of your business’s current A/R aging.
  • A list of your customers, addresses and phone numbers.
  • Your business’s most recent financial statements.
  • Documentation that verifies your business’s legal name.
  • An example of a typical invoice.

The business factoring application requests information about your company, receivables and customers. Required documents are slightly different for corporations than for partnerships and sole proprietors.

2. Underwriting and due diligence:

  • Look for business UCC liens.
  • Look for any tax liens.
  • Check owners’ credit and background.
  • Check your customers’ credit.

During underwriting, the factor will check for any UCC-1 financing statements filed under your company name. A UCC-1 financing statement is registered with your Secretary of State and gives public notice of any creditor who has a secured loan on any of your assets. Factoring companies normally require a first position on your accounts receivables. they want to ensure that your company’s accounts receivables are free of any liens. If a UCC-1 indicates that a creditor has an existing lien on your accounts receivable, then you must discuss the situation with your factoring company.

3. The business factoring agreement:

  • The invoice factoring agreement.
  • A personal guarantee.
  • A limited power of attorney.
  • Notice of assignment.

Once the factoring company completes the underwriting process, you’ll sign all the necessary documents. Most factoring companies require a personal guarantee for additional security. Some factoring companies require a limited power of attorney in case something drastic happens to the business, such as the owner’s death or incapacity.

4. Filing a UCC-1 financing statement.

Upon preliminary or final approval, the factoring company will perfect its lien by filing a UCC-1 financing statement on your business’s accounts receivables and/or your company’s total assets.

Choosing a Factoring Company


Never settle for the first factoring company you see in a Google search or factoring article. Do your homework and research before selecting a factoring company. Your best resource is our very own website FactoringClub.com, a factoring company directory devoted to over 100 factoring companies with in-depth detail and information. FactoringClub also has free consulting services.

Industry

In addition to finding a factoring partner who will work with you and provide exceptional customer service, you also want to find a factoring company that provides factoring services in your industry. Although accounts receivable financing is pretty standard, some industries that require factoring expertise. Niche industries include:

If you conduct business in one of these industries then you need to find an invoice factoring company that has experience with your industry. Just like you would want to find a dermatologist to take care of your skin problems or a podiatrist to take a look at your foot problems, finding a factoring specialist ensures you get the best possible factoring service.

Interest and Knowledge

When talking to a factoring company representative, gauge the attitude, helpfulness and transparency of the company representative. When talking to the company rep, ask yourself the following questions:

  1. Is the sales person really interested in my business?
  2. Does the person answer my questions knowledgeably and clearly?
  3. Is the person transparent and easy to understand?

Jot down your initial impressions about the company during your conversation. Later, you can review your notes if you can’t clearly remember the discussion. Finding objective information about a company can be extremely difficult, if not impossible. If necessary, contact FactoringClub to recommend a factoring company for your needs.

Factoring Rates

Present your company’s situation and cost factors to prospective factoring companies. A factoring company should give you an idea of their cost based on the following:

  1. How much you intend to factor per month.
  2. The expected average invoice days outstanding.
  3. Your customers’ credit-worthiness.

Some factoring companies calculate costs on a weekly, monthly or even daily basis. Others may determine costs based on a flat, one-time fee, no matter the collection days outstanding. Flat fees are usually better if your invoices are outstanding more than 45 days. Weekly or monthly rates can get very expensive if your collections age more than 45 days.

Additional Fees

There may be setup costs incurred when you arrange to receive services from invoice factoring companies. Those fees may include a basic application processing fee, as well as due diligence fees that the factoring company charges to perform credit checks on your customers or run background checks on your company. Some factoring companies will negotiate with you on these fees. Many factoring companies don’t charge setup or application fees.

Another common fee is a monthly minimum fee. Ask the factoring company if they require a monthly invoice volume amount. Some factoring companies charge a fee if you don’t meet a minimum invoice amount per month. This is common if you negotiated a lower rate based on an expected volume. Otherwise, avoid monthly minimum fees, especially if your sales are seasonal or sporadic.

Contract Terms

All factoring companies have contract terms regarding termination and cancellation fees. Be careful with contracts requiring a long-term contract (more than one year) or expensive cancellation fees. Many factoring companies only required 30 days notice. As with many business services, terms might not be the same for all companies. You may be able to negotiate terms according to your company’s situation. Don’t be afraid to ask.

Finding the right factoring company for your business needs requires both research and common sense. It’s time well spent as you can save both time and trouble for your efforts. As you see in this article, a variety of factors such as industry, factoring rates and contract terms will influence your decision.