Understanding Invoice Factoring

How invoice factoring works

You sell an invoice to a factor, receive most of its value upfront, and the factor collects from your customer and pays you the remainder, minus fees.

The steps are straightforward:

1. You deliver goods or services and issue an invoice to your business customer.
2. You sell the invoice to the factor. The factor advances a percentage, often a large share of the face value.
3. The customer pays the factor directly, usually after being notified.
4. The factor pays you the reserve, the remainder of the invoice, less its fees.

In this illustrative example, you invoice $50,000 on 45-day terms. The factor advances $40,000 right away, and after your customer pays, you receive the rest minus fees of, say, $1,500. Your net is $48,500, and you got most of the cash in days instead of weeks.

It is a sale of an asset, not a conventional loan, though the cash flow effect is similar.

Recourse vs. non-recourse factoring

With recourse factoring, you must buy back or replace invoices your customer does not pay. Non-recourse shifts some of that risk to the factor, usually for a higher fee.

Recourse. If your customer fails to pay, you owe the factor. This is the more common arrangement and usually costs less.

Non-recourse. The factor absorbs losses if the customer cannot pay because of insolvency, but typically not if the customer disputes the work. The fee is higher, and the factor chooses which customers and invoices it accepts.

Read the definition carefully. Non-recourse rarely means "no risk to you." Disputes, missing paperwork and breach of contract can still put the loss back on the seller.

Other terms to review: whether you must factor all invoices or can pick individual ones, the length of the contract and exit fees. See single invoice factoring.

What factoring costs

Costs include a discount or factor fee, often charged per period the invoice is open, plus possible service, setup and wire fees. Total cost rises the longer your customer takes to pay.

Factors price in different ways. Some charge a flat rate on the invoice. Others charge a rate for each week or month the invoice remains unpaid. Additional fees may include application, due diligence, ACH or wire charges, and minimum monthly volume penalties.

Because pricing differs, convert every quote to total dollars and an annualized cost. A fee that looks small per month can be large over a year. In this illustrative example, a 2 percent fee for 30 days on a $50,000 invoice costs $1,000. If your customer takes 60 days, the cost may double. That is a high annualized figure compared with many loans, though it may still be worth it if the cash lets you take on profitable work.

Always ask for a full fee schedule in writing.

Who factoring fits and who it does not

Factoring suits B2B firms with creditworthy commercial customers and long payment terms. It does not fit consumer sales, very small invoices or tight margins.

Common users: staffing firms, trucking and freight carriers, wholesalers, manufacturers, government contractors and service firms who bill other businesses on net-30 to net-90 terms.

It works best when:

• Your customers are other businesses or government entities with good payment records
• Invoices are large enough to justify fees
• Margins comfortably absorb the cost
• Growth requires cash faster than customers pay

It is a poor fit for retail, restaurants and other cash-sale businesses. Customer notification can also affect relationships, since the factor contacts your customers to collect. Related reading: invoice financing, construction factoring and medical factoring.

Factoring vs. a line of credit

Factoring is tied to specific invoices and customer credit. A line of credit is tied to your business, and you draw as needed. Costs and control differ.

For a deeper comparison, read business line of credit vs. invoice financing.

What ROI Funder can offer instead

If you have slow-paying customers, working capital or a line of credit can bridge the gap, based on your business revenue instead of individual invoices.

ROI Funder does not place invoice factoring or accounts receivable financing. If factoring suits you, compare factors directly on total cost. If you would rather keep control of customer relationships and collections, consider:

• Business line of credit, which you draw on while invoices are outstanding and repay when they pay, with 24-72 hour turnaround on complete files
• Working capital, for a fixed amount that covers payroll and suppliers

These are not always a fit. If your revenue is below $20,000 a month, or your business has under 6 months of history, ROI Funder cannot help yet. We consider 500+ FICO, 6+ months in business and $20,000+ monthly revenue, with a soft credit pull to apply. We start from payback math and show true cost before you sign.