With invoice factoring, companies sell their accounts receivable to a service provider so that they receive the invoice amount immediately, which boosts cash flow. Here we show you exactly how this type of financing works and what its advantages and disadvantages are.
What is invoice factoring?
Invoice factoring is a method of invoice financing. A company sells its open invoices to a factoring service provider, who pays the invoices immediately for a fee. The advantage for the company is that it receives payment immediately, regardless of the invoice deadline, and thus generates a stable cash flow.
The factoring service provider then takes care of collecting the payment from the company's customers itself, so that the company no longer has to worry about it.
Invoice financing vs invoice factoring
Invoice financing and invoice factoring are very similar in principle. With factoring, a company sells its accounts receivable to a service provider who then takes care of collecting payment from the debtors.
With invoice financing, the company also receives the invoice amount immediately from the service provider for a fee. If it then receives payment from its customer, it must pay this amount back to the service provider. Invoice financing is therefore a type of credit provided by a third party.
Invoice factoring vs invoice discounting
In invoice discounting, the company also receives a cash advance from a third party, but not for the full amount of the invoice. If the customer then pays his invoice, the service provider receives the full invoice amount and then pays the outstanding amount back to the company. This method also maintains a stable cash flow for the company.
Invoice factoring in the UK: Example
A company has accounts receivable of £100,000 which it sells to a factoring service provider. The fee for this service is 5%, i.e. the service provider keeps £5,000 for itself and transfers a sum of £95,000 to the company.
This increases the company's cash flow and liquidity on a one-off basis, enabling it to pay its own bills, make investments or build up reserves.
Invoice factoring: Disadvantages & Advantages
Disadvantages
Invoice factoring is only worthwhile for companies that have many customers and a high level of receivables. Factoring service providers prefer it if they can spread the risks over as many customers as possible.
In addition, it is often not possible to sell only individual invoices to a factoring service provider, as the contracts are usually structured in such a way that the company always has to sell its entire accounts receivable to the service provider, and often has to commit to it for a year or longer.
Depending on the level of risk, the factoring fees also increase. If a company has many customers with a poor payment record or a bad credit score, it will have to pay more for the factoring service.
Advantages
With invoice factoring, a company receives an improved cash flow that is easily predictable. This makes it easier to plan investments and distribute cash optimally within the company.
Companies also no longer have to take care of their receivables management themselves and chase after unpaid invoices, as the service provider takes care of it.
Financing through invoice factoring is usually cheaper than taking out a bank loan and companies find it easier to conclude a factoring agreement than a loan.
Invoice factoring for small business
Whether invoice factoring for small businesses is an option depends on a number of factors. Since this service involves fees, the company must first be able to afford factoring, i.e. be able to forego part of its income. This is only possible if there is a well-run business model.
Many factoring service providers also only work with companies that are active in the B2B sector. Companies that mainly have private individuals as customers can therefore usually not make use of factoring.
How much does it cost to factor invoices?
The higher the accounts receivable of a company, the lower the factoring fees. The service providers charge a so-called factoring rate, which ranges from 0.5% to 5% of the accounts receivable and is paid by the company on a monthly or annual basis.
Invoice factoring: Meaning for businesses
Invoice factoring can be very important for some companies when it comes to securing cash flow. If a company wants to save on its receivables management, outsourcing it to a service provider can even save costs in the long term, as its own employees no longer have to take care of it.
If you are thinking of using invoice factoring for financing, it is advisable to compare different providers with each other, as the conditions can vary greatly. Use the conditions to calculate whether this financing method is worthwhile for you and whether you will not only receive a short-term cash boost, but also benefit from this type of financing in the long term.
