Invoice finance fundamentals: What is factoring and how does it work?

Here’s our guide for SMEs considering using invoice finance, accountancy firms learning how factoring could benefit their clients, and individuals joining the invoice finance industry. This piece is the third in our Invoice Finance Fundamentals series. Click here for our invoice finance overview, or here for our guide to invoice discounting.

Factoring is a way for businesses to borrow money in the short term, secured against invoices owed to them that have not yet been paid. It’s a self-liquidising form of debt: as the invoices are paid, the borrowed money is paid back to the invoice finance lender.

What distinguishes factoring from other forms of invoice finance is that the lender takes responsibility for collecting the invoices. It’s an important distinction that is particularly relevant to smaller businesses that don’t have an internal credit control team.  

What are the benefits of factoring?

Factoring enables you to get hold of money owed to you without having to wait weeks or months for it to be paid. By effectively speeding up payments, factoring improves cash flow and injects working capital into the business sooner. For businesses with uneven cashflow, growth plans or urgent bills to pay, this can be valuable. In some case it can make all the difference between surviving and going under – even for SMEs with plenty of work coming in.

An important benefit of factoring is that it reduces administrative work and improves credit control efficiency. The lender – or ‘factor’ – takes responsibility for managing the borrower’s sales ledger, monitoring payments and chasing overdue invoices. This frees up more time for the borrower-business’ owners and management to focus on sales, customer service and operations.

A factoring arrangement provides better payment oversight, outstanding debt monitoring and customer creditworthiness assessment. And when it comes to collecting unpaid invoices, reminders from a finance provider can be significantly more persuasive than ones from the business.  

Factoring also supports growth – as your sales grow, your facility grows too.  

How does factoring work?

You provide goods or services to your customers as normal, and invoice for them. You then ‘sell’ or assign the invoices to the lender, which advances you a percentage of the value of the invoices to the business. Funds may be available in as little as 24 hours or as long as two weeks or more.

Your customers pay the lender directly, and if payment is late, the lender chases them. Once invoices are paid, the lender pays you the remaining invoice amount minus a fee.

Here’s an example:

Let’s say you run a recruitment agency that has invoiced a client £20,000 for staff you supplied. Your client has 60 days to pay, but you need cash now to pay your own employees and contractors.

1. You invoice your client for £20,000, payable in 60 days.

2. The lender advances you 85% of the invoice value: £17,000.

3. The customer is notified of the arrangement.

4. 61 days after the invoice was sent, the lender sends a letter to your client reminding them that their payment is late. After hearing nothing, three days later the lender follows up with a forceful second reminder.

5. Startled into action, your client pays the £20,000 directly to the factoring company.

6. The lender releases the remaining £3,000 to you, less its fees and interest.

What type of business is factoring suitable for?

Factoring suits businesses that sell goods or services to other businesses on credit terms, have a need for working capital, and would benefit from handing over the time-consuming work of managing invoices and chasing payments. It effectively combines finance with an outsourced credit-control service. However, note that the arrangement is disclosed to customers – that is, customers know their supplier is working with a factoring lender, or ‘factor’. In some cases, this may undermine their confidence in your business.

Here are some types of companies that often benefit from factoring:

• Wholesalers and distributors – often have high invoice volumes, relatively tight margins and spend substantially on stock before customers pay.
• Manufacturers – need to fund materials, production and wages while waiting for customers to settle invoices, sometimes over lengthy payment terms.
• Recruitment and staffing agencies – often pay contractors weekly, while clients pay monthly or later. Note that the factoring model is often adjusted slightly for these businesses, to form a lending product called ‘recruitment finance’.
• Transport and logistics companies – have to pay for fuel, maintenance and driver costs before customers settle their bills.
• Business services companies providing services such as cleaning, facilities management and security – have recurring invoices alongside substantial payroll costs.

When would a business use factoring?

Here are some typical scenarios where factoring could be a valuable solution:

• Rapid growth in a business, where expenditure has run ahead of earnings. 
• Difficulties getting customers to pay on time, where the additional clout and credit control expertise that a factor provides would make a difference. 
• Owner-led businesses, where the owner or small management team spend too much time chasing invoices. 
• Smaller companies with little spare cash to cover unexpected costs, and where a lack of credit history and balance sheets make it hard to qualify for a traditional loan.  
• Businesses that have had a difficult financial period or have had problems repaying loans in the past – factoring companies focus on the creditworthiness of your customers rather than the business applying.

What different types of invoice discounting are there?

Different kinds of factoring arrangements offer different benefits. Here are the key types.  

• Recourse factoring: if an invoice remains unpaid, you are ultimately responsible for it and will have to pay back the lender.
• Non-recourse factoring: you are protected from the risk of non-payment and the lender takes on most of the risk – for an additional fee.
• Spot factoring: instead of borrowing against your whole ledger, you borrow against a specific invoice – usually a particularly large one.  
• Whole ledger factoring: you assign all your invoices, gaining access to a larger source of credit. This is the ‘traditional’ form of factoring.

Want to find out more?

Factoring is an invaluable and under-utilised way for established businesses to access cash using their invoices. It’s important to understand if it’s the right type of invoice finance for your business, though, as others are available. For more information, click here for the other articles in our Invoice Finance Fundamentals series.

About Dancerace

Dancerace is the complete, connected software platform for banks and lenders providing invoice finance products – including invoice discounting. Today, 4/5 of the UK’s highest-rated IF lenders depend on Dancerace to power their IF business.