Invoice Factoring

Invoice Factoring

Invoice factoring is a type of business funding that allows your business to release cash by selling unpaid invoices to a third-party company.

Finding the best invoice factoring for your business

By Laura Rettie, Personal Finance Journalist.

Laura Rettie

Invoice factoring is useful for businesses, but it can be confusing. Learn about how it works and how to find the best provider with our guide.

What is invoice factoring?

Invoice factoring, sometimes referred to as factoring debt, is a form of invoice finance available to a business where you sell your invoices to a debt factoring company, also known as a funder.

When you initially sell your invoices, you'll be doing so at a discounted price, receiving a percentage of the total value of the invoices. This percentage can range between 80-90%, but this will be dependent on many factors.

Once an invoice is sold to a debt factoring company, they will have complete control, meaning they're now responsible for getting your customer to pay the invoice. Once the invoice is paid, you'll get the remainder of what you were owed, minus any fees.

Invoice factoring is a helpful way for a business to make sure they have consistent cash flow, allowing them to invest in the company and pay bills without being dependent on invoices being paid on time, which can take weeks or even months of chasing.

How does invoice factoring work?

Invoice factoring should usually follow the same process:

  1. The business raises and sends an invoice to the customer as usual.
  2. As well as sending it to your customer, you'll also provide a copy of the invoice to your debt factoring company.
  3. The factoring company will then verify the invoice and ensure it's legitimate. Once complete, you'll receive a percentage of the invoice's value immediately.
  4. The factoring company will then be in total control of getting your customer to pay the invoice and they will have the authority to send reminders to your customer to pay the invoice.
  5. Once the invoice is paid, the funds will go into a bank account controlled by the factoring company.
  6. From this payment, the company will then pay you the remainder of what you were originally owed on the invoice, minus any fees.

It's highly unusual to send a single invoice to a debt factoring company. Instead, it’s common practice to send multiple invoices at once from a sales ledger.

However, the more invoices you send to your factoring company, the more costly the service may be. This is because factoring companies prefer minimal invoices of higher value than multiple invoices of smaller amounts because of the administration associated with each invoice.

Types of invoice factoring

Invoice factoring can be two types: recourse or non-recourse. For both, the process is still the same, although the type you choose will impact what happens if a customer is unable to pay their invoice:

  • Recourse invoice financing: This is where you, the business, are liable to pay the cost of an invoice if it's left unpaid.
  • Non-recourse invoice financing: This is where the factoring company will pay the cost of any unpaid invoices, meaning your money is protected.

Because non-recourse is far riskier for the financing company, these will usually cost you more. If your business has a good relationship with your customers and you're confident the invoices will be paid, recourse invoice financing may be better for your business because it'll be cheaper.

If you're working with clients you don't trust and want to protect your money; then it may be worth using non-recourse invoice financing. The costs may be more expensive, but you'll be able to protect the majority of the value of the invoice.

Generally, invoice factoring is not regulated, meaning you're not protected if a factoring company goes bust.

High street banks also offer invoice factoring, but you'll likely need to have a business account with that bank to be considered. They're also very selective about who they provide factoring to, so it's likely you may not be able to get invoice factoring via this method.

Thankfully, there are other options. In the UK, there are over 100 different factoring companies of various sizes who are able to provide specialist factoring solutions to suit your business.

How much does factoring invoices cost?

There will be a number of fees and charges you'll have to pay when factoring debt. The specifics of these fees will be dependent on your business's current situation and income. Instead of being a fixed monthly payment which is the case for typical business loans, the amount you pay each month should scale and alter depending on a few factors, such as:

  • Your monthly turnover
  • Amount of the invoice
  • The number of invoices
  • How risky the invoices are

Discount rate

When you sell your unpaid invoices to a factoring company or funder, you're doing so at a discounted price. The discount rate is the amount the factoring company are saving.

This rate is determined by many factors and will be larger if you're a smaller business sending more risky, lower value invoices.

Service fee

The service fee is more similar to a standing charge and covers the ongoing servicing on your factoring facility.

Your turnover and income dictate the service fee you’ll pay. The more your business earns, the lower your service fee. Service fees are usually a percentage of the total value of the invoices you send.

Both service fees and discount rates are added together to determine how much you're paying for invoice factoring.

Let's show this with an example:

You find a factoring company that buys your invoice for 85% of its value upfront. You send that factoring company monthly invoices of £20,000 and receive £17,000 immediately.

Sending £20,000 a month suggests to the factoring company that you have a yearly turnover of around £200,000. Because this is relatively low, you'll get a large service fee, for example, 3% of the value of your monthly invoices. This means you'll pay a fee of £600 a month.

In this example, the £20,000 worth of invoices is made up of multiple different invoices of small payments. This requires more credit control work, resulting in a higher discount rate, such as 4% of your monthly invoices. This means you're paying £800 a month on your discount rate.

In total, it means once the invoice is paid to the factoring company by the customer and you get given the remaining value of the invoice, you'll only get £1600 (not the £3,000 remaining) because you'll pay £1400 in fees and charges.

These rates and fees may fluctuate with the growth of your business. If you start sending invoices worth £50,000 instead of £20,000, you'll likely be offered different rates, usually at a lower percentage. This is because businesses with a higher turnover are considered less risky for factoring companies.

Once your business starts making a certain level of profit and grows to a large enough size, it may be better to switch to invoice discounting, an invoice financing option that best suits larger businesses.

Invoice factoring is best suited to small and mid-sized businesses.

What is the difference between invoice factoring and invoice financing?

Invoice financing is the umbrella term that invoice factoring falls into and is a specific type of invoice financing, of which there are a few.

Despite being related, these terms shouldn't be used interchangeably.

There are also a couple of other invoice financing options within invoice financing. These are:

Invoice discounting

This is similar to invoice factoring, with one key difference being that your customers will not be made aware you're using this service. This is because instead of handing the responsibility of the invoice to the factoring company, you will still be responsible for getting payment from your customer and collecting and managing your invoices.

Selective invoice finance

The critical difference with selective invoice finance is that instead of sending all your invoices in one sales ledger to a factoring company, you can instead send a select few invoices you want to get funds from immediately.

Why would a business use invoice factoring?

Invoice factoring is helpful for businesses because it ensures that you'll have consistent cash flow. Invoices can take time to be paid, with many companies potentially having to wait weeks and even months to get paid for a service they’ve provided.

If you're a small business, you may not have the financial capacity to wait for this payment and may need money immediately to invest in your business or pay staff and other bills. Invoice factoring gives your business access to these funds and removes the responsibility of chasing customers for their payments.

Invoice factoring can also help businesses provide better customer services to their clients. Many clients may expect multiple payment options, such as being able to pay within 30, 60, or 90 days. For many small businesses, waiting this long for payment won't be financially viable.

However, you can offer these terms to your customers and still receive most of your payments instantly with invoice financing.

Businesses also opt to use invoice factoring because it's a type of business finance most companies should qualify for. Small businesses may not have the financial history or strength to get traditional business loans or other financial products. However, because these business loans are secured against your invoices, most businesses can get them, regardless of their size.

The information provided does not constitute financial advice, it’s always important to do your own research to ensure a financial product is right for your circumstances. If you’re unsure you should contact an independent financial advisor.

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Frequently asked questions

Do you have to have good credit to use a factoring company?

Invoice factoring is not a credit product that incurs debt, meaning no credit checks will be performed on your business. This means you should be able to use invoice factoring even if your company has no credit report or poor credit history. 

Factors considered for eligibility include the creditworthiness of your customers, so you may still be denied invoice factoring if they aren't deemed reliable payers.

Is invoice factoring worth it?

It depends on the financial situation of your business. Many small businesses find invoice factoring to be a highly beneficial way of generating consistent cash flow from invoices that may not be paid promptly. This constant cash flow makes it easier to pay bills, invest in their stock, and better manage their funds. 

However, if your business is operating on a tight budget, you may not be able to afford the fees associated with invoice financing.

If you're a larger business, invoice financing may not be as useful as other business finance options available to you.