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How Does Invoice Factoring Work?
- Small business owners sell outstanding invoices to a factoring service (the factor) at a discounted rate
- The factor advances a lump sum up to 95% of the value of the invoice
- The factor then collects all payments directly from the client
- The factor sends the remaining balance to the business, minus any fees, which is typically an agreed-upon percentage
Invoice Financing and Invoice Factoring: What’s the Difference?
The main difference between invoice factoring and invoice financing is which party is responsible for collecting on the unpaid invoices. With invoice financing (also called accounts receivable financing), the customer retains full control of collections, not the invoice financing company. In invoice factoring, the factoring company purchases the unpaid invoices and takes over the collections process.
After submitting your invoices to the lender for invoice financing, you’ll receive the amount of the invoice minus a percentage as payment. Once the client pays you, you satisfy the agreement with the lender. While it may be helpful to have the lender collect unpaid invoices on your behalf, understand that you will have less control over the collections process and that your clients may become aware of your cash flow shortages.
How to Apply for Invoice Factoring
Many business owners question how much the invoice factoring process costs. The truth is, it depends. There are a variety of factors that go into the approval process for an invoice factoring agreement, such as creditworthiness, the number of invoices a business will submit for financing and even the type of industry a business is in. However, there is typically a factoring fee of between 0.05% and 4% on average. Additionally, business owners may come across these fees along the way:
Monthly Minimum Fees
If a business produces less than ideal results after a credit check, factors may require businesses to commit to a minimum amount of invoicing submitted each month. If a business fails to meet the minimum, the factor can charge additional fees.
Many factoring companies charge businesses a fee to keep their accounts running and open. This type of fee usually occurs each month.
If a business owner signs a long-term contract and desires to terminate their invoice factoring agreement, there may be cancellation or termination fees. This typically will run a business a small percentage of their credit line.
Due Diligence Fees
Sometimes, a factor will check into the reliability of a business’ clients beyond face value (whether or not the client is a credit risk, if they have any liens against them, etc). Each time the factoring company performs this check, they may charge the business a due diligence fee. This fee typically ranges in cost from a few hundred dollars to several thousand.
Invoice Factoring Fees
Factoring companies typically calculate discounting rates using a variable fee structure where the factoring company charges a flat fee for the first 30 days, plus a small additional fee for every 10 days that the invoice remains unpaid. Other factoring companies offer a flat fee structure where a one-time fee is charged upfront and remains the same regardless of how long the invoice remains open. Late fees can add up so be sure to check your customers’ payment histories when choosing which fee structure is best suited for your business.
Invoice Factoring: Advantages and Disadvantages
FAQs About Invoice Factoring
What does it mean to factor an invoice?
Factoring an invoice means selling it to a lender in return for a discounted advance. Then, the lender collects the unpaid invoice from your customers on your behalf.
Is invoice factoring a bank loan?
Invoice factoring is not a traditional bank or business loan. Factoring allows you to release untapped working capital from your accounts receivable to meet your immediate cash needs.
What is the difference between invoice factoring and invoice discounting?
Invoice factoring is when a business sells its invoices to a third party and then the factoring company controls the sales ledger and collects the debts. Invoice discounting allows you to draw money against your invoices, however, the business maintains control over the administration of your sales ledger.
What are the types of invoice factoring?
There are two main types of invoice factoring: recourse and non-recourse. Recourse factoring is the most common type of invoice factoring in the United States. Recourse factoring involves an agreement that if your customers do not pay the factor, the business owner is responsible for compensating the factor. With non-recourse factoring, the factor assumes all the risk and if the customer fails to pay, the business owner does not owe anything to the factor.
Other Financing Options
Still looking for the right fit? Check out all of Credibly’s business financing options.