Invoice factoring: how it works and when to use it

When you’re faced with cash flow problems, it’s vital to have a route to easily accessible funding, so you can get your cash position back on track. One fast and straightforward way to do this is by using invoice factoring. 

• Invoice factoring allows you to sell your unpaid customer invoices for cash.
• The invoice factoring company buys the invoice, pays you the cash and then collects the outstanding amount directly from your customer.
• It’s a quick way to access capital when cash is needed fast.
• Invoice factoring is best suited to balancing out your cashflow position and accessing liquid cash. It’s not a replacement for larger-scale business loans.
• Factoring is good for B2B businesses with higher turnovers, higher-value invoices and agreed payment terms of 30, 60 or 90 days etc. 

What is invoice factoring?

Invoice factoring is a kind of invoice financing that involves selling your outstanding invoices to a factoring company at a small discount. The factoring company pays you the cost of the invoice, providing you with ready cash. They then collect payment directly from your customers – essentially replacing your accounts receivable function.

By selling the invoices, you can quickly access liquid cash, making invoice factoring ideal for when you have urgent cash flow gaps, or need working capital to keep specific parts of the business funded and operational.

What’s the difference between factoring and invoice discounting?

When using invoice factoring, your business sells an unpaid invoice to a third party, the factoring company or ‘factor’. The factor then takes full control of collecting the invoice payment from your customer. 

In contrast, invoice discounting is a loan that’s secured against your invoices. With discounting, your business retains ownership of the invoice and remains responsible for collecting the payment from the customer.

Why do businesses use invoice factoring? 

The key advantage of invoice factoring is the speed with which you can access liquid cash. When you’re faced with an urgent cash flow issue, you’ll need to quickly find working capital to plug this cash gap.

Most types of business finance require an application and review process, so a loan or additional funding can be agreed with the lender. This can take time, leaving you with a hole in your finances and no way to fill it.

By making sensible, tactical use of invoice factoring, you can bring additional capital into the business, pay off any debts and boost your overall cash position.

‍

{{business-funding-on-your-terms="/components"}}

‍

How does invoice factoring work in practice?

Being able to rapidly access extra capital is a major boost for the flexibility of your financial management. Knowing that you can partner with an invoice factoring company gives you a cash flow ‘safety net’ that stops the business from going into a negative cash flow position, keeping the whole business well-funded. 

But how does invoice factoring work once you enter into this kind of partnership with a trusted factor?

Here’s a step-by-step guide to the invoice factoring process:

1. You sell your products and/or services to your customers 
2. You raise an invoice for the goods/services sold 
3. This invoice is sold to the factor (the invoice factoring company) 
4. You receive upfront payment based on the value of the invoice (typically 70–90% of the invoice value) 
5. The factor is now responsible for chasing payment of the invoice, taking on the role that would usually be undertaken by your accounts receivable team 
6. Your customer pays the value of the invoice to the factor 
7. The balance, minus any fees from the factor, is returned to you

An example of invoice factoring in action

Invoice factoring is most common in industries where margins are tight, payments are historically slow, or overheads and costs are high. Companies in sectors such as construction, manufacturing and recruitment will commonly make use of invoice factoring to overcome either high initial expenditure, or slow customer payment.

Let’s look at an example of how factoring works for a fictional car valeting business, called Pristine Valeting Ltd. 

Pristine has a large corporate client, Global Tech PLC. Pristine provides valeting services to Global’s entire fleet. The revenue is good, but the corporate client is slow to pay and often misses the due deadlines for payment.

Slow payment is causing cash flow issues for Pristine, so they approach an invoice factoring company to sell the Global Tech Plc invoice for the current month.

Here’s how the factoring process would work in our Pristine/Global tech example:

Does invoice factoring affect my business credit score?

Entering into an invoice factoring arrangement does not have a negative impact on your overall business credit score. 

Although factoring is a type of financing, it’s actually seen as the sale of an asset, rather than the business taking on a debt. As such, it’s not perceived as a risk to your creditworthiness as a company – in fact, it could actually have a positive benefit on your business credit score. 

The key business benefits of using invoice factoring

Used as a part of a sensible finance and funding strategy, invoice factoring has the potential to be an incredibly useful tool in your finance toolbox. 

Responsible use of factoring can:

• Give you faster access to funds: Invoice factoring gives you access to additional capital as and when it’s needed. This provides a flexible foundation for managing the overall capital and cash position of the business.
• Improve your cash flow: When you have pressing cash flow issues, factoring helps you to rebalance your cash flow by quickly turning your outstanding invoices into much-needed capital.
• Outsourcing responsibility for credit control: Once the factor buys your invoices, the factoring company takes on the responsibility of chasing your customers for payment. This frees up time for your credit control team to target other debts.  
• Can help to support growth: If customers are taking longer to pay their invoices, factoring is one way to maintain your working capital, while income levels are low. This helps you continue to trade and reinvest in your key projects and growth plans.

Is invoice factoring the best route to finance in all situations?

Factoring works in many circumstances, especially where you have a large number of outstanding invoices that are holding back your cash position. But short-term lending, like iwoca’s Business Loans, gives you more control over cash flow without involving factoring company fees and third parties chasing your customers for payment. 

Who is eligible for invoice factoring in the UK?

Invoice factoring is aimed primarily at business-to-business (B2B) companies and isn’t suitable for business-to-consumer (B2C) enterprises. You’ll also need to operate agreed payment terms (30, 60 or 90 days etc.) with your clients, so there’s a gap between the factor buying the invoice and then having to collect payment.

Some sole traders, partnerships and limited companies will be eligible for factoring, but many invoice factoring companies will set a turnover threshold, limiting the service to companies with a minimum £100,000 annual turnover. 

What are the potential drawbacks and risks of invoice factoring to consider?

While factoring can be an extremely useful financial tool, there are certain drawbacks to bear in mind when making your decision.

For example

• Costs and fees: When you use factoring, you won’t end up with the full value of the invoice. Factors will take off their own fees and additional costs, so it can work out to be less effective, financially, than some other finance options.
• Loss of control over customer relationships: When you sell the invoice, you pass the debt-collection process over to your factoring company. Customers may object to dealing with a third party, and you’ll have little control over how the factor communicates with (and treats) your valued customers.
• Contracts may lock you in: Some factoring companies will want to lock you into a 12 or 24-month contract, to guarantee an income stream. However, you can use selective (or spot) factoring on a more ad-hoc basis too. 
• Not always suitable: Factoring works best when you have higher invoice values and larger client numbers. Because of this, factoring may not be suitable for businesses with a small client base or low invoice values.

Is invoice factoring suitable for small businesses?

Invoice factoring can be suitable for some small businesses, but you’ll need a high turnover (around £100,000 or more), agreed payment terms with your customers and high-value invoices that will deliver decent fees for the factoring company. 

Alternatives to invoice factoring and how to choose

When it comes to financing your business, it pays to have multiple routes to funding and a number of options when it comes to balancing your capital levels. 

Invoice factoring is just one option of many, so it’s sensible to have an awareness of other ways to bring cash into the business for different purposes. 

You could consider:

• Invoice discounting: Although similar to invoice factoring, with invoice discounting you use the value of your invoices as collateral against a short-term loan. Remember that, with discounting, you’re still responsible for the debt and the collection of payment from your customer. 
• Business overdrafts:  If you have a good working relationship with your bank, you may be able to agree to a business overdraft. Overdrafts allow you to continue spending, even when you’ve spent all the money in your account (as long as this overdraft amount is paid back within the agreed terms). 
• Short-term loans: Where you need larger sums of money, without the negative implications of invoice factoring, a short-term loan can be a great alternative. An iwoca  Business Loan can help you access up to £1 million, with between 1 day and 60 months to repay the loan. 
• Revolving credit facilities: Revolving credit is an ongoing form of finance. As the borrower, you can access money repeatedly and repay it over time – as  long as the credit facility remains open. The number of payments isn’t fixed, but there is a set limit on the amount of credit you can access. 

What’s the right finance channel for your business?

The finance channel that’s right for you will depend on a number of factors, including your turnover, business performance and your overall business credit score.

Large banks will want to see signs of a good business credit score before agreeing to a loan or an overdraft. However, specialist business finance providers, like iwoca, will be more focused on your future business performance and revenue generation. 

Aim to keep your credit utilisation to a minimum, pay your suppliers on time and keep your cash flow under tight control, to help reduce your risk level in the eyes of lenders. 

iwoca: your flexible route to business finance

If you’re looking for finance to smooth out your cash flow, invest in future projects or just cover your overheads while you wait to get paid, an iwoca Flexi-Loan can provide up to £1m, without giving up control over your invoices and customer relations.

Our small  business finance is designed to fit around your needs, giving your flexibility and control when it matters most. 

• Borrow between £1,000 and £1 million
• Terms of between 1 day and 60 months
• Apply in minutes and get access to funds in a matter of hours
• No early repayment fees and only pay interest on what you draw down. 

Apply for an iwoca business loan today

‍