Define Invoice Factoring

Invoice factoring provides cash flow support for businesses.

Invoice factoring, or simply factoring, is a corporate finance service in which businesses sell unpaid invoices to a third party in return for immediate payment. Factoring has been around for centuries in different forms and improves business cash flow as well as provides credit control benefits. Organizations that supply a factoring service, referred to as factors, can be independent or a subsidiary of a bank.

History

According to MIT’s "Quarterly Journal of Economics," factoring has been around for at least 600 years. Early factoring services were often used to finance international trade deals. Advances in communications technology, as well as financial law reform, assisted factoring’s evolution in the United States and United Kingdom and allowed the process and practice of its modern form a freer reign.

How Factoring Works

A business raises an invoice for the customer with instructions to pay the factor directly. It also sends a copy to the factor. The factor then pays an agreed percentage (generally 75 to 90 percent) of the invoice to the business and takes over responsibility for recovering the debt. When the customer settles the debt, the factor pays the balance of the invoice to the business, minus its fees and any interest accrued.

Advantages of Factoring

Factoring improves a business' cash flow by removing the standard delay associated with invoice payment, easing the burden of overheads and essential payments. Improved cash flow helps accurate financial planing and forecasting. The factor also provides credit control and so removes the need for a business to dedicate in-house resource to recover payment.

Factors offer a swift route to finance without requiring onerous guarantees. This is because companies base factoring decisions on the diligent assessment of the business strategy and the creditworthiness of its customer base.

Factoring for Start-Up Businesses

A factoring facility can support the growth of a fledgling business without the entrepreneur having to surrender control or become mired in extensive reporting. It often can deliver start-up finance swiftly without the need for further security. Funding availability is constrained only by the volume and size of invoices a new company generates, so the facility can grow quickly in line with early sales success. Many factors provide additional services that protect against unpaid invoices and bad debt.

Costs and Considerations

Typical factor fees range from 1.5 to 3 percent over a base rate. This fee does not include interest charges, which are calculated daily. Additional fees for credit management and administration vary depending on a business’ turnover, invoice and customer volume.

Factoring charges decrease a business’ profit margins. Having a factoring facility in place reduces the availability of other borrowing options: book debts are committed and cannot be used to secure further finance.

Some analysts have viewed factoring as a lending option of last resort for businesses that otherwise cannot secure more traditional finance, although this stigma is lifting.

References

• "The Quarterly Journal of Economics"; Four Centuries of Factoring; William Hurd Hillyer; February 1939
• "Harvard Business Review"; Factoring; Owen Jones; February 1939
• "Harvard Business Review"; Factoring as a Financing Device; Herbert R. Silverman; September 1949
• "BusinessWeek": The Pros and Cons of Factoring
• "Financial Times": Banks’ invoice financing gets cool reception