Invoice factoring
Selling unpaid customer invoices to a finance company for immediate cash, less a fee.
In short
- The factor usually advances 70% to 90% up front and pays the rest, minus its fee, when the customer pays.
- With recourse, the business bears the loss if the customer doesn't pay. Without recourse, the factor does, at a higher cost.
- It is often used by growing businesses whose customers pay slowly.
Invoice factoring turns receivables into cash before customers pay. A business sells its unpaid invoices to a factoring company, the factor, which advances most of their value right away. When the customer pays, the factor releases the remaining balance minus its fee.
How it works
- The business issues an invoice to its customer as normal.
- It sells the invoice to the factor, which advances, for example, 85% of the face value.
- The customer pays the factor directly, often instructed by a notice on the invoice.
- The factor pays the business the remaining 15%, minus a fee that depends on how long the customer took to pay.
Types of factoring
- Recourse: if the customer does not pay, the business must buy the invoice back. Cheaper, and the most common form.
- Non-recourse: the factor takes the credit risk of the customer's insolvency. More expensive, and usually limited to creditworthy customers.
- Invoice discounting: the business keeps collecting from its customers itself, and customers may never know financing is involved.
When it makes sense
Factoring suits businesses with creditworthy customers and slow payment terms, such as staffing firms, manufacturers and distributors selling to large retailers. It costs more than a bank loan, but it is based on the customers' credit rather than the business's own, so it can be available when a loan is not.
Worked example
Factoring a $40,000 invoice
A manufacturer invoices a national retailer $40,000 on 60-day terms. It factors the invoice and receives an 85% advance, $34,000, the next day. The retailer pays in 58 days. The factor charges 1.5% per 30 days, or 3% here, $1,200, and releases the balance of $4,800. The manufacturer received $38,800 in total, two months earlier than it otherwise would have.