Invoice Factoring Explained
For SMEs, choosing the right type of business finance can be a game-changer. It may determine which growth opportunities can be seized, and which are missed. But navigating the range of finance options available in today’s market isn’t always so easy.
That’s why, in this article, we’ll attempt to solve one piece of that puzzle by shining a spotlight on invoice factoring. Ibis world estimate that the UK’s factoring industry is worth around £3bn in 2021, with around 140 businesses offering business finance solutions. It’s a well-trodden method of financing that’s used primarily by small to medium-sized businesses in the UK, and the industry has grown by around 2.5% over the last five years.
With that in mind, stick with us as dive into:
- What invoice factoring is
- The distinctions between invoice discounting and factoring
- Whether this is the right finance method for your small business
What is invoice factoring?
Once sales of a product or service have successfully been made, a business may find itself with a backlog of unpaid invoices. How long they’re likely to be waiting for those invoices to materialise can differ from business to business, however it could be weeks or even months before that cash becomes readily available in the bank as debit.
That’s where a factor comes in. An invoice factoring lender could purchase your receivables to offer you a cash advance on your unpaid invoices. This means that the factor:
- Gives you a portion of the debt (normally the majority) that you’re owed up front.
- Takes ownership of your invoices, becoming the credit controller.
- Pays you the remainder of your debt minus a fee once invoices have been collected.
That’s essentially how invoice factoring arrangements work. They can free up cash in the short-term that could be used, for example, to fund investments or boost working capital.
A prerequisite to signing a factoring agreement is that you’ll need to evidence that your business has a substantial amount, or steady flow, of unpaid invoices.
What’s more, a lender may want to conduct a risk assessment to dive deeper into your invoices – getting an understanding both of quality, and the likelihood that invoices will be paid in full. The result of this assessment should help determine:
- Whether you’ll be offered money.
- The exact rates you are to be offered.
- What additional fees, and terms and conditions, will become part of your agreement.
Invoice discounting vs factoring
It’s worth drawing a distinction between discounting and factoring - as there is one fundamental difference between these two similar finance products. When you sell your receivables to factor, your customers or clients will be subject to the factor’s credit control (or debt collection) processes. This has a couple of potential implications:
- The customer may notice that they’re paying into a bank account owned by the factor, rather than the company they originally bought from.
- Any communications pertaining to the customer, such as complaints or queries, would be handled by the factor’s customer service team.
Conversely, an invoice discounting solution would allow businesses to retain control over their sales ledger and debt collection.
Is a factoring solution right for me?
The natural question, then, is whether invoice factoring is a good option for your SME. To help you find an answer, here’s our list of pros and cons.
Benefits of factoring
- Immediate buying power. The cash advance element of a factoring agreement is undoubtably its most attractive feature.
- Outsourced admin. When a factor takes control of your receivables, they’ll also take on responsibility for ensuring those invoices are followed through. This could potentially save your team valuable time.
Downsides of using a factor
- Can be expensive when compared to the interest rates and fees you’ll typically find with more traditional lending agreements.
- Fees can be complicated. There’s often a flat processing fee charged for handling the invoices, as well as a factor fee that is dependent on how long it takes for your customers to pay their invoices.
The decision of whether or not you should use a factor is one only you can make. It’s worth noting some similar finance options that may be relevant to you if you aren’t dead set on factoring.
One of these is invoice financing, in which you retain ownership of your invoices rather than outsourcing debt collection. Another is our own innovative product at Rapid Cash, in which our AI syncs with your accounting software. This automation enables you to choose which of your invoices you would like to borrow against.
We hope this article has helped you get an understanding of whether invoice factoring is right for you. If not, you may benefit from reading our insights into the world of alternative business funding.
What is an invoice factoring broker?
A broker serves to connect businesses with factors, using their expertise and connections to help facilitate lending agreements.
Invoice factoring rates - what should I expect?
We always recommend reading the terms and conditions before signing a lending agreement. That said, some common rates you’re likely to find when looking for a factoring agreement are:
- 3% of the invoice taken as a processing fee
- Around 1% of the invoice taken weekly based on how long it takes for the invoice value to be secured.
What invoice factoring cost should I be aware of?
Beyond the processing fee and factor fee, it could be worth keep an eye out for any hidden fees in the terms and conditions. It’s also useful to get a clear understanding of what would happen if a customer were to default and find themselves unable to pay their debts.
To be eligible for Rapid Cash you must be trading for more than 6 months, have an annual turnover of at least £100k and either be a Limited Company or Limited Liability Partnership in England and Wales. Additionally, you need to invoice other businesses and use one of the following digital accounting software: Xero, Quickbooks, Sage 50, Kashflow, FreeAgent and Netsuite.
Security and guarantee required. Product fees may apply.