Invoice factoring is the practice of selling invoices to a third party at a discount. It is also known as debt factoring and invoice finance. Invoice factoring can be used as an alternative to maintaining a line of credit (e.g. a business credit card). It will not, however, build a business’s credit score in the same way as using true credit does.
Example of invoice factoring
John and Jane Smith Ltd operates in an industry where it’s standard to offer long payment terms. It’s therefore quite common for them to have to wait three months for their clients to pay their invoices. Unfortunately, the supplier John and Jane Smith Ltd uses has much shorter payment terms. Typically, it wants to be paid within a month.
As John and Jane Smith Ltd is a relatively young company, it doesn’t have a lot of cash reserves. Likewise, it doesn’t have much of a credit history. This means that it would be hard for the company to access regular business finance products such as bank loans. It, therefore, decides to use invoice finance instead.
Each time John and Jane Smith Ltd invoices its customers, it sends the invoices to a third-party factoring company. The factoring company provides 80% of the value of the invoice up front. When the end customer makes payment, the factoring company deducts its fee and then sends the remainder of the money to John and Jane Smith Ltd.
Advantages of invoice factoring
Invoice finance is a way for companies to extend the payment terms they offer to their customers while still getting quick payment themselves. In addition to managing slow-paying customers, using invoice finance can spare SMEs the work of dealing with late-paying customers. The factoring company can manage these. In fact, they will probably have staff trained to manage credit control both ethically and legally.
Disadvantages of invoice factoring
While invoice finance can be very useful, it can also have its drawbacks. Here are the main ones.
The obvious disadvantage of invoice factoring is the factoring company’s fee. Essentially, you’re paying for convenience (particularly speed).
Whether or not this cost is justified depends greatly on your situation. In a nutshell, you need to assess honestly whether or not your payment issues can be resolved by changes on your side.
If they can, then sorting out your business processes is likely to be far more economical than invoice factoring. If they can’t, then your choice is likely to be between using invoice finance and using some other form of financing. The choice will then boil down to costs and convenience.
When doing these sums, make sure to consider all the potential add-on costs of invoice factoring. For example, if the factoring company has to pursue customers for payment, they may well charge extra fees for this extra service.
Also keep in mind that, by default, you are required to repay the factoring company if an invoice ends up having to be written off. If you want to avoid this, use non-recourse factoring. This is effectively invoice factoring plus insurance and hence carries an additional cost.
In a traditional factoring scenario, the customer pays the factoring company directly. This meant it was obvious to the customer that their supplier was using invoice finance. Now, there is confidential factoring. This essentially means that the customer is not made aware that they are dealing with a factoring company but may still figure it out.
If you are using confidential factoring, then you may also want or need to use Customer Handles Own Credit Control (CHOCC) factoring. Depending on your reasons for using invoice finance, managing credit control yourself may be anything from a minor inconvenience to a major pain point.
In general, invoice financing companies are looking for long-term commitment and a high volume of invoices. There are options such as selective factoring (also known as spot factoring) where factoring companies take on a smaller number of invoices. It is, however, fairly unlikely that SMEs would meet the qualifying criteria for these.