Invoice financing — commonly known as “factoring” — is a form of financing widely used by businesses to access cash trapped in outstanding invoices or accounts receivable.
In simplest terms, a factor purchases a client’s receivables (invoices), advancing to the client upfront a portion of the receivables’ face value in cash. The remainder of the invoice amount is paid to the client once the factor gets paid by the client’s customer. This process is referred to as “the sale of accounts receivable” and is one of the oldest and most common forms of commercial finance, dating back to ancient Mesopotamia and Rome, when Romans would sell promissory notes, which were a written promise to pay another party, at a discounted price.
Invoice financing is often appealing to businesses that are small, just starting up, or have recently experienced some financial difficulty and cannot obtain conventional financing, as they are deemed “not creditworthy” by banks. Banks focus narrowly on a company’s profitability, cash flow, or assets in assessing ability to repay a loan.
Invoice finance providers or “factors” look beyond a client’s near-term financial condition to the strength of obligations owed by the customers of that client — the client’s receivables. With this approach, a client receives funding based on the ability of its customers to pay an invoice, rather than the client’s credit alone.
This has two noteworthy features: (1) Factors spread repayment risk across a client’s multiple customers rather than to the client alone or just to a single customer. This is referred to as “diversification.” (2) Often, a client’s customers are stronger financially than the client itself. Imagine a small toy company with limited credit history that sells to Wal-Mart, a company with very strong credit. With invoice financing, a factor can finance the toy company based on the financial strength of Wal-Mart, which most likely will pay its bills.
Why do businesses use Invoice Financing?
Invoice financing is used as a quick source to generate working capital; however, not every business relies on invoice financing for the same reasons. Several scenarios could lead a business to use invoice financing, like:
Going extended periods without sufficient cash flow (i.e., slow-paying customers)
A need to make payroll
To purchase additional inventory, supplies or add headcount
To accommodate rapid growth or large orders
Difficulty in obtaining traditional bank financing
Reinvesting profits for future growth
How does Invoice Financing work?
Invoice financing involves three parties: a seller, a buyer, and a factor.
Here’s the invoice financing process broken down into a few steps:
The seller delivers a product or provides a service and generates an invoice to the buyer
The seller submits the invoice to the factor for purchase
The factor purchases the invoice from the seller by paying most of the invoice amount (typically up to 90%) to the seller
When the invoice is due — say 30, 45, or 60 days out — the buyer pays the invoice to the factor
The factor releases the remaining invoice value to the seller, less a fee (typically 1-2%)
Is your business a fit for Invoice Financing?
Invoice financing works for many but not all kinds of businesses and has some specific requirements:
Sell goods or services to commercial businesses (B2B) You must sell goods or services to businesses, not consumers. Since consumers typically pay with cash or a credit card, and vendors receive cash immediately, there are no invoices to finance.
Bill customers on payment terms You must sell to customers on “terms” (e.g., due in 30 days), not cash. Otherwise, there are no invoices to finance. Invoice financing turns invoices or receivables into immediate cash.
Invoice for delivered goods or services Your customers must be legally obligated to pay your invoices. Therefore, you must have billed your customer after delivering goods or services, creating an invoice.
Have a creditworthy customer base Your customers must be creditworthy or “financially able” to pay your invoices. Creditworthiness is based on data from readily available databases such as Dun & Bradstreet or PayDex, financial statements, outside research, or from the analysis of an underwriter.
No existing pledges (liens) on your receivables Your receivables must not be pledged as security to someone else, like an existing lender. Otherwise, the existing lender will have to “subordinate” so the factor has a first-priority claim on the receivables. Since your receivables are the primary source of repayment, the factor will need to be in “first position” over other lenders.