Invoice factoring prevents late payments from causing cash flow problems. This external financing can free up funds, yet only 2% of SMEs used it in 2020 [1].
Here we explore invoice factoring, the types of businesses it benefits, and UK best practice.
What is invoice factoring?
Invoice factoring is a type of finance where a business raises money by selling a majority (typically 70-90%) of the value of an unpaid invoice to a specialist third party, known as an invoice factor. This process allows businesses to receive payment more quickly, but they receive less than the full value of the invoice. The process can help release cash in accounts receivables and working capital.
Can I use invoice factoring if I’m an exporter?
Invoice factoring is more common for domestic trading, but you can use it for international trade finance.
Invoice factoring vs invoice discounting
Selling your invoices to a factoring (or finance) company can happen in two ways. You can get a loan based on the value of your accounts receivable, or the company can purchase them from you (less a percentage fee) and chase the account(s) themselves.
An invoice discounter will advance you a percentage of the value of your invoices, but you still have to manage and collect the invoice payments. Your customers won’t be aware that a third party is being used.
An invoice factor takes over your debtor book, accounts receivables, and credit control process and chases customers for you. Usually, customers will know you’re using a factor.
Using invoice factoring or invoice discounting are just two of many ways to help you manage cash flow. You can also improve your working capital by using the American Express® Business Gold Card to pay for your business expenses. Its payment terms of up to 54-days¹ allow you to keep your money in your account for longer while you wait for invoices to be paid.
You’ll earn one Membership Rewards® point² for £1 spent on the Card, which can be redeemed as statement credit – allowing you to free up further cash to reinvest in your business.
What are the different types of invoice factoring?
There are several invoice factoring facilities, including:
Full-service factoring/ full factoring/ non-recourse factoring
These are all different terms for the same thing – a type of invoice factoring providing a complete service, including credit control and credit protection. Within approved limits, the factor assumes credit risk for trade debts overdue by 60-90 days, sets credit limits, approves customers, handles collections and bookkeeping, and provides finance.
Recourse factoring
This loan helps recoup a lender’s investment if a borrower doesn’t pay and the underlying asset’s value is insufficient. It’s a form of secured financing where the lender targets the debtor’s other assets or takes legal action to pay off the debt for you.
Advance factoring/ discount factoring
This process involves the factor purchasing your accounts receivable before the customer payment date as a loan with interest or as a discounted partial prepayment of the purchase price (discount factoring). The advance rate is typically 70-90% of the purchase price that the factoring company would otherwise pay you for the accounts receivable.
Selective (or spot) invoice factoring and whole turnover
With the ‘selective’ approach, you choose which invoices you want funded. With ‘whole turnover’ (which many SMEs prefer), all invoices are considered for funding and sent to the factor weekly. It can be useful for freeing cash quickly.
How does invoice factoring work?
There are several UK factoring companies, from small invoice finance providers to large enterprises.
Payment from an invoice factor happens in two phases: an advance on the invoice and a payment once the invoice is paid (minus the factor’s fees). The invoice factoring partner pursues payment from customers, helping clients settle their accounts.
The business using the invoice factor is then paid the balance of the value minus the factoring fee when the invoices are collected.
To access the invoice factoring UK market, you need to complete the following steps:
Step 1: Eligibility A debtor or factoring company risk assesses you and provides a quote. You may need to provide your annual turnover to show you meet their minimum threshold.
Step 2: Contract Agreement Once you have reviewed and signed the invoice factoring agreement, the factor provides the advance.
Step 3: Collection The factor will proceed with your customer’s outstanding invoice total collection.
Step 4: Final payment The factor will pay the remainder of the invoiced amount minus the fees once collected from the customer invoices.
A small business invoice factoring example
Since 2006, Chinese pancake manufacturer Ming Foods has used invoice factoring for UK products, which its CEO, Sam Duong, says has helped his cash flow management.
“Let’s say you want to take advantage of buying some stock before a price rise,” he says. “You talk to your finance company and ask to advance more from invoices that have been sold to them. Say from 75%-85%.
“This releases instant cash flow for you to purchase at a discount or before the price rises. The finance company charges a small fee for the privilege, and everybody wins in their own way.”
When to use invoice factoring
“Factoring can be very helpful to small businesses, as factors have efficient collection procedures,” notes Michael Bickers, editor of World Factoring Yearbook. “Also, finance is provided in line with sales, so as a business grows, so does its funding.”
Invoice factoring could suit your business if you:
- Invoice between 30-90 days.
- Don’t want a long-term debt.
- Have high-value invoices that could impact cash flow if they’re not paid on time.
- Need to free up money fast and can afford the factoring fees.
What are the costs of invoice factoring?
Costs are based on either a discount rate or a service fee. The final amount differs based on the company size and the risk to the lending partner.
The discount rate is typically 1-5%, and fees occur during application, as well as a factor fee for each invoice fee processed.
The advantages of invoice factoring
- You’ll have your cash quickly because you’re not waiting for a customer to pay.
- You have time to focus on other business areas.
- Your invoices are the collateral, so you don’t put your real estate or equipment at risk.
Disadvantages of invoice factoring
- It’s only suitable for businesses that sell B2B on credit.
- Providers take a percentage, and finance companies charge different rates, from 1%-5% of turnover for invoice factoring to around 0.2-0.5% for invoice discounting.
- Once you sell your invoices, that asset belongs to the factoring company, and they’re at liberty to chase your clients. If a client doesn’t like how the factor deals with them, you could risk losing their goodwill.
- If you want to terminate the agreement but haven’t reached the minimum annual fee, you’ll pay the difference.
- The maximum payment period on purchases is 54 calendar days on Gold & Platinum Business Charge Cards and 42 calendar days on the Basic Business Charge Card; it is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date.
- If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
- Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
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