What Is A Factoring Company & How Does Factoring Work?
If you're looking to increase cash flow by selling invoices you may be wondering how factoring companies work. Find out what an invoice factoring company does and how it can benefit you.
A factoring company can help B2B business owners solve cash flow problems caused by unpaid invoices. Keep reading to find out what a factoring company is, how invoice factoring works, and whether factoring your invoices is the right move for your small business.
Table of Contents
- What Is A Factoring Company?
- How Does Factoring Work?
- Pros & Cons Of Invoice Factoring
- How Much Does A Factoring Company Charge?
- What Is The Difference Between Invoice Factoring & Invoice Financing?
- How Is Invoice Factoring Different From A Business Loan?
- What Industries Do Factoring Companies Work For?
- How To Choose The Best Factoring Company For Your Business
- Factoring Company FAQs
- Should You Work With A Factoring Company?
What Is A Factoring Company?
A factoring company is a company that buys a business’s unpaid invoices at a discount, then collects the money owed directly from the business’s customers. Businesses use factoring companies to get immediate cash flow, rather than waiting for an invoice to get paid on its regular 30-90 day payment schedule.
How Does Factoring Work?
The way factoring works is pretty simple. The company (the “factor”) buys your customers’ unpaid invoices at a discount, paying up to 90% of the invoice value upfront.
The factoring company waits for your customers to pay them directly. Once invoices are paid in full, you get the last 10%, minus a factoring fee.
Pros & Cons Of Invoice Factoring
Invoice factoring is advantageous because it solves an immediate cash flow issue without taking out a loan. However, invoice factoring does come with certain risks and costs.
- Immediate access to cash for bills or new projects
- Stable cash flow for businesses with seasonal highs and lows, slow-paying customers, and/or rapid growth
- Easier to get than business loans
- Doesn’t affect your credit score
- Your customers still get flexible payment terms
- Invoice factoring fees cut into profit margins
- Possible factoring denial depending on your customers’ creditworthiness
- Loss of control over customer payments
- May have to repurchase invoices if the factoring company doesn’t get paid
How Much Does A Factoring Company Charge?
A factoring company typically charges a fee between 0.5% and 5% of either the total invoice amount or the amount of cash paid upfront.
Many different factors influence how much you are charged, such as the:
- Number of invoices you want to factor
- Size of each invoice
- Level of risk in your industry
- Creditworthiness of your customers
- Amount of time it takes your customers to pay
- How much of your business comes from the customer who has not yet paid their invoice (your customer concentration)
In general, businesses with a varied customer base, a larger number of invoices to be factored, and a customer base with decent credit will get better rates due to the decreased amount of perceived risk on the part of the factoring company.
How Invoice Factoring Fees Are Calculated
Some factoring companies charge a one-time flat fee upfront, while others charge a tiered fee or a variable fee that accrues over time.
For example, say you want to factor a $100 invoice.
One factoring company charges a flat fee of 2% of the total invoice value, which comes to $2.
Another factoring company may also charge a tiered fee of 1% per month. If your customer pays in 30 days, you pay a $1 fee. If they pay in 60 days, then in total you pay a $2 fee. If they pay within 90 days, you end up paying a $3 fee.
A third factoring company charges a variable fee. You start at a 0.5% fee the first month, then a 1% fee the next month, then a 2% fee on the third month, and so on.
Factoring companies will charge more if you choose non-recourse factoring, a form of factoring where you don’t need to re-purchase invoices if your customers underpay or don’t pay. The factoring company takes on all the risk that comes with repayment, which is why it charges a higher fee.
What Is The Difference Between Invoice Factoring & Invoice Financing?
Invoice factoring is a sale. You’re selling your unpaid invoices and the factoring company collects invoice payments over time, charging a fee for the service. Factoring is not a loan, since you are not responsible for paying the factoring company, your customers are.
Invoice financing is a loan or line of credit where a financing company pays a cash advance, with your unpaid invoices serving as collateral. Once your customers pay you in full, you send back the loan amount, plus a lender fee.
In both instances, you get a lump sum at the time of agreement and you’ll pay a fee to a third-party company. However, with invoice financing, you’re still responsible for collecting your customer’s payments. You get to control your customer interactions since they won’t have to pay a third-party company, but you’re also left with the risk of customers not paying you.
How Is Invoice Factoring Different From A Business Loan?
With a small business loan, you are expected to put up some form of collateral, meet certain eligibility requirements based on your business’s creditworthiness, and pay in regular intervals with a fixed or floating interest rate. The length of the loan repayment period is predetermined.
However, invoice factoring is not a loan, so you don’t need any collateral. Eligibility and fee rates are based on the creditworthiness of your customers, not your business. You also get paid in two lump sums, one at the time of the agreement, and the other when invoices are paid in full.
What Industries Do Factoring Companies Work For?
Factoring companies work for the following industries:
- Construction and landscaping
- Staffing companies
- Service providers
- Call centers
- Commercial-level food and beverage
- Oil and gas
- Textile and apparel
- Waste management
- Real estate
How To Choose The Best Factoring Company For Your Business
The best factoring company is unique for each business, simply because all businesses vary in size, revenue, credit score, amount of time in business, customer base, number of invoices, and more.
To find the right factoring company for your business, you have to find a factoring company that understands your industry, figure out how its factoring process works, and determine whether your business qualifies for the company’s services. Also, make sure the company offers the best terms and lowest fees while also meeting your business’s cash flow needs.
Step 1: Compare Factoring Companies
Not all factoring companies are built the same. It’s important to find a transparent company that has fair prices and understands your business.
Step 2: Find Out What Their Factoring Process Is Like
Most factoring companies have a similar core set of services, but there are unique aspects to each company’s day-to-day operations. Answer the following questions before choosing which companies to work with.
Step 3: Examine Fees & Other Factoring Requirements
There’s more fine print than just a discount rate. Consider the following as you research invoice factoring providers.
Factoring Company FAQs
Should You Work With A Factoring Company?
If you don’t have the time, credit score, or desire to get a traditional business loan or line of credit, invoice factoring can be a great way to solve your business’s current cash flow problems.
Invoice factoring works best for B2B businesses with a creditworthy customer base. If you decide to use invoice factoring for your small business, be sure to get some invoice factoring quotes, read contract terms thoroughly, and check out user reviews to find the best factoring company for you.