Summary: Factoring is a type of financing that helps improve the cash flow of companies that have slow-paying invoices. This form of financing gives the client access to immediate funds, which can then be used to pay business expenses and support growth.
In this article, we explain how factoring works and go over the key details to help you determine if factoring is right for your company. We cover the following subjects:
- What is factoring?
- How does factoring work?
- Typical fees
- Account setup process
- How are invoices financed?
- Qualification requirements
- Advantages and disadvantages
- Common business uses
1. What is factoring?
Factoring allows companies to finance invoices that are due to be paid by their customers in 30 to 90 days. It allows a company to convert its accounts receivable into working capital. This provides immediate funds to support operations and growth.
Factoring lines are structured to provide revolving financing to the client. The client can request funding as new invoices are issued. Transactions settle once the end customer pays according to their usual terms.
One important feature of factoring is that transactions are typically structured as an asset sale rather than a loan. Your company sells the invoice to the factoring company at a discount in exchange for immediate funds. Consequently, factoring has simple qualification requirements and is available to small businesses.
a) Recourse vs non-recourse
In a recourse factoring transaction, the client assumes the risk if an invoice is not paid. The client must return the advance and cover any earned fees. Most factoring companies handle recourse by allowing the client to submit new invoices to cover the amount, rather than asking the client to send funds directly.
In a non-recourse factoring transaction, the factoring company assumes the risk if an invoice is not paid under certain circumstances. In most cases, this protection applies when an invoice remains unpaid due to the customer’s declared insolvency or business closure. However, the exact terms vary by factoring provider.
Note that non-recourse agreements usually exclude disputed invoices. Invoices subject to a dispute are typically subject to recourse and returned to the client.
Read “Recourse vs. non-recourse factoring” to learn more.
2. How does factoring work?
Most factoring companies buy your invoices in two installments. The first installment is called the advance and typically covers around 85% of the invoice’s value.
The advance is deposited in your bank account when you submit an invoice for financing. Note that the advance rate varies based on industry and risk profile and can range from 70% to 98%.
The remaining 15%, less the factoring fee, is paid once your customer pays the invoice in full. These funds are deposited into your bank account as the second installment. This payment settles the transaction.
Read “How do factoring companies buy accounts receivable?” to learn more.
a) Single-installment transactions
Some transactions in the trucking industry, typically for owner-operators and small fleets, may use a single-installment transaction with a flat fee. In these transactions, the factoring company advances up to 97% of the invoice value in a single installment. Note that the advance rate varies by transaction and provider.
The transaction settles when the shipper pays the invoice. Keep in mind that single-installment transactions are typically slightly more expensive than conventional two-installment transactions.
3. Typical factoring fees
Factoring companies base their rates on the size of the line, the quality of your invoices, and the creditworthiness of your customers. Generally speaking, companies with high factoring volumes and high-quality accounts receivable qualify for lower rates.
The typical factoring rate ranges from 1.15% to 3.5% per 30 days, though rates can be structured using different tiers. Examples include:
4. How to set up a factoring account
Establishing a factoring account requires some initial due diligence by the finance company. The process is generally quick and straightforward. Most accounts can be set up within a couple of days if you submit a complete application and respond promptly to requests for information.
Step 1: Find the right factoring company
Most factors are small to medium-sized companies that specialize in specific industries. In our experience, the best approach is to find a factoring company with experience in your industry. The factor should be familiar with your customers and their processes.
It’s best to work with factoring companies that have been in business for a decade or more. This longevity shows that they have the financial wherewithal to survive economic cycles.
Step 2: Application and due diligence
The next step is to fill out and submit the financing application along with the required supporting information. Each factor has its own application process, though most are similar.
Factoring companies need the application to evaluate the transaction and determine if it’s a good fit for both parties. During due diligence, factors evaluate whether your:
For the application, most factoring companies request the following:
Due diligence is usually quick, and you can often get a proposal the same day you submit your application.
For more information about the application process, visit our “Factoring Application Tips” resource center.
Step 3: Proposal and contract
The factoring company will send you a proposal after it finishes reviewing the transaction. Most proposals have three key pieces of information:
Once you sign the proposal, the factor performs its final due diligence and sends the contract to you. We suggest reviewing the contract with your attorney before signing it to ensure you understand the important details. Once you sign the contract, your account is ready for its first funding.
Step 4: Initial account setup
In this step, the factoring company sends a Notice of Assignment (NOA) to every customer whose invoices you want to factor. The NOA is a standard industry document and is used by every factor. It advises the customer’s accounts payable department on how to handle payments on factored invoices. This process is done once for each customer.
5. How are invoices financed?
This section explains the steps for receiving an advance and settling your factored invoices. You follow these steps whenever you need to finance a batch of invoices.
Step 1: Funding invoices
Every factor has its own submission process, though most are similar. Usually, you submit the invoices you want to finance through an online portal or by email. Once the factor receives and verifies the invoices, it deposits the first installment (advance) into your bank account. You repeat this step every time you want to finance a batch of invoices.
Step 2: Settling transactions
Factors settle each transaction when your customers pay their invoices. Once an invoice is paid, the factor remits the remaining balance, less the factoring fee, to you as the second installment. This deposit settles the transaction.
6. Qualification requirements
Qualifying for factoring is much easier than qualifying for other types of business financing. The main requirements are:
a) Your customers must have good commercial credit
This is the most important requirement to qualify for factoring. The transaction is structured to leverage the credit strength of your customers to your advantage.
b) Your invoices must be free of liens
Factoring companies provide financing by purchasing the financial rights to your invoices. Consequently, your invoices must be free of liens. Factors will buy only invoices for which they have a first-position UCC filing.
c) Margins must be above 15%
It’s best to use this financing solution if your gross profit margins are at least 15%. If you are unsure, speak with your CPA.
d) You must have good invoicing practices
Good invoicing practices are also an important requirement for financing your receivables. Your invoices must have well-defined payment terms and must have all the necessary supporting documentation to help ensure smooth collections.
e) Tax issues must be manageable
A key advantage of receivables factoring over other solutions, such as business loans, is that it may be available to companies with tax problems. However, these tax problems must be manageable and surmountable with financing. In these cases, a payment plan with the appropriate tax authority may be required.
f) There must be no open bankruptcies
The company and its principal owners must not have an active bankruptcy. Past bankruptcies must be properly discharged.
7. Advantages and disadvantages
Like most forms of financing, invoice factoring has both benefits and drawbacks. The following section summarizes the most important ones.
i) Advantages
Invoice factoring offers several advantages, especially for companies that need to improve cash flow or cannot qualify for conventional financing. They include the following:
a. It provides you with immediate cash
The most important advantage is that factoring can provide funds comparatively quickly. It provides the working capital your business needs to cover expenses and take on new clients.
b. It lets you provide payment terms to clients
Offering payment terms to clients is often challenging for companies that don’t have an adequate cash reserve. A factoring program allows you to offer terms to your clients, since you can always factor their invoices and receive the advance quickly.
c. It helps you manage the credit of your customers better
One important challenge of offering payment terms is determining which clients have good business credit. Factoring companies can act as a credit department by letting you know which companies have good credit and should get payment terms.
d. It is relatively easy to get
Getting approved for a factoring line is easier than getting approved for a conventional financing product, such as a line of credit. Furthermore, the line can be deployed quickly.
e. The line can increase as you need it
Factoring lines are adaptive by design. The line can increase very quickly as your revenues from creditworthy customers increase.
f. It can be a short-term solution
Many factoring companies don’t require a long-term agreement. Consequently, you won’t have to use the line if it has outlived its usefulness.
Note: This varies by factoring company. Check your factoring agreement.
g. It uses your invoices as collateral
The primary collateral for the line is your company’s accounts receivable. This is an important feature for small and midsized companies whose largest asset is a roster of creditworthy customers.
h. It does not require you to give up equity
Factoring companies do not require you to give up equity. The business relationship with the factoring company is transactional and has an end date. This benefit is often overlooked by business owners.
Selling equity is a complex process that requires competent legal advice. It typically requires you to give up a portion of the ownership and future profits of your company. An often-overlooked risk is that the equity partner may want to become involved in management decisions in the future.
i. It can be used by small businesses
Factoring is one of the few financing alternatives that can be used by small companies. Many factors can work with clients who invoice as little as $10,000 per month.
ii) Disadvantages
Factoring lines have some disadvantages that should be taken into consideration. They include the following:
a. It costs more than a line of credit
Factoring is more expensive than many comparably sized alternatives, such as a line of credit, a ledgered line, or a bank loan. It works best for companies with margins above 15%.
b. It solves only one problem
While factoring lines are flexible, they can only help companies whose cash flow problems are due to slow-paying invoices. It won’t help much if your company has structural problems or needs to purchase fixed assets, such as expensive equipment.
c. It is labor-intensive
Factoring lines can be more labor-intensive to operate than conventional financing lines. For example, getting an advance often requires sending invoice copies and backup documentation.
d. Finance companies contact your customers
Factoring requires some customer contact. The factor typically sends a Notice of Assignment with payment instructions and may also verify invoices through a vendor portal, by email or by phone. Some business owners prefer to avoid this involvement, especially when they want to keep their financing arrangements private.
e. Finance companies don’t handle bad debt
Factoring can improve cash flow, but it does not make collection problems disappear. The business will typically be responsible for the loss if a customer refuses to pay, disputes an invoice, or becomes insolvent. The main exception is non-recourse factoring, and even then, protection is limited to the specific circumstances covered by the agreement.
8. Common business uses
The following examples show how companies commonly use invoice factoring to manage cash flow.
a) Manufacturing company with slow-paying customers
A manufacturer sells products to business customers that pay in 30 to 60 days. This creates a cash flow problem because many of its suppliers need to be paid quickly. The company uses factoring to access cash sooner and cover payroll, materials, and other operating expenses.
b) Growing consulting company waiting on receivables
A consulting company is adding clients and hiring employees, but its customers pay on 30- to 60-day terms. Factoring provides working capital to support growth while the company waits for its outstanding invoices to be paid.
c) Staffing company with weekly payroll
A staffing company has a common challenge. It must pay employees every week, but its clients pay invoices several weeks later. Factoring provides the funds to help meet payroll, enabling the company to grow the business with confidence.
d) Trucking company covering fuel and operating expenses
An owner-operator delivers loads for shippers that pay in 30 to 60 days. However, the trucking company has immediate expenses. The trucking company uses freight bill factoring, a customized factoring product for truckers, to get cash sooner and cover fuel, driver pay, maintenance, and other operating expenses.
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Marco Terry is the Managing Director of Commercial Capital LLC and has over two decades of experience in asset-based finance. He has worked with small and mid-sized companies across the United States, Canada, and Australia. Marco holds a Master of Science in Finance.