What Does an Invoice Factoring Company Do?

What Does an Invoice Factoring Company Do?

An invoice factoring company purchases a business’s outstanding invoices, converting future sales revenue into immediate working capital. This provides quick cash flow but requires the business to sell control of its sales ledger and debt collection process in exchange for a fee.

In the UK, maintaining consistent cash flow is crucial for the survival and growth of Small and Medium-sized Enterprises (SMEs). When customers take 30, 60, or even 90 days to pay their invoices, businesses can face significant liquidity gaps. This is precisely where an invoice factoring company steps in.

Essentially, an invoice factoring company acts as a financial intermediary, providing working capital finance by buying a business’s debt (its outstanding invoices). They accelerate payment timelines, allowing the business to access the bulk of the invoice value almost immediately, rather than waiting for the customer (known as the debtor) to settle the bill.

How Invoice Factoring Works: The Step-by-Step Process

Factoring is a straightforward financial service, though it involves several distinct steps. It is a transactional process where the factoring company effectively becomes the new owner of the debt owed by the customer.

1. Invoice Issuance and Submission

The process begins when your business delivers goods or services to a customer and issues an invoice, typically offering credit terms (e.g., 30 days). Instead of waiting for the customer to pay, the business submits this invoice to the factoring company.

2. The Advance Payment

Once the factoring company verifies the invoice and the creditworthiness of the debtor, they advance a percentage of the total invoice value to the business. This advance is usually between 80% and 90% of the gross value. This money is transferred almost instantly, addressing immediate cash flow needs.

• If the factor is assessing the financial standing of the business requesting the service, they will perform due diligence, which may include reviewing company accounts and, in some cases, the personal credit history of the directors.

3. The Factoring Company Takes Control

A key characteristic of factoring is that the factoring company takes over the responsibility for managing the sales ledger and collecting the debt. This is often referred to as a “disclosed” arrangement, meaning the customer is aware that a factoring company is involved.

4. Final Payment and Fee Deduction

When the customer eventually pays the full amount of the invoice to the factoring company, the factor deducts its fees and charges (the factoring fee and the discount rate) from the remaining balance (the reserve). The rest of the reserve is then remitted back to the business. The reserve payment concludes the transaction.

Key Differences: Factoring vs. Invoice Discounting

While often grouped together under the umbrella of ‘invoice finance’, factoring and discounting serve slightly different needs and structures:

Invoice Factoring (Disclosed & Managed)

Factoring is considered a debt management service. It involves:

• Selling the debt outright to the factor.
• The factor managing the sales ledger and chasing payments.
• The customer knowing the factoring company is involved (disclosed).

Invoice Discounting (Confidential & Self-Managed)

Invoice discounting, conversely, is primarily a loan secured against the outstanding invoices. It involves:

• The business remaining responsible for chasing and collecting the payments from its customers.
• The factoring company remaining confidential (undisclosed) to the customer.
• The business receiving the funds but retaining control over the debt management.

Factoring is generally preferred by smaller businesses lacking dedicated credit control teams, while discounting is often used by larger businesses wishing to maintain tighter control over customer relations.

Understanding the Costs and Fees

Invoice factoring is a powerful tool, but it comes with costs that must be carefully calculated to ensure profitability. Factoring fees are generally based on two primary elements:

1. The Factoring Fee (or Service Fee)

This is the charge for administering the sales ledger and managing the debt collection process. It is typically a percentage of the total turnover factored. This fee generally ranges from 0.75% to 3% of the invoice value, depending on the volume of invoices, the number of customers, and the difficulty of collections.

2. The Discount Rate (or Interest Charge)

This is essentially the interest charged on the money advanced to the business. It is calculated similarly to an overdraft interest rate, based on the Bank of England base rate plus a margin. It only applies to the amount of money drawn down and the length of time it takes the customer to pay.

Additional Charges

Factors may also impose other charges, such as setup fees, termination fees, and fees for dealing with late payments or disputes. Businesses must review the contract terms thoroughly to understand the total cost of the facility.

Who Benefits from Invoice Factoring?

Factoring is not suitable for every business, but it provides specific advantages for those that:

• Have long payment terms: Businesses that rely heavily on 60 or 90-day payment cycles can significantly improve immediate cash flow.
• Are rapidly growing: Fast-growing businesses often face a gap between purchasing raw materials or funding staff and receiving payment for their work. Factoring helps bridge this gap.
• Deal with creditworthy business clients (B2B): Factoring is usually only available for B2B transactions. The factor primarily assesses the financial health of the customer (the debtor), not necessarily the SME seeking the funding.
• Require outsourced credit control: SMEs that lack the resources or expertise to manage collections efficiently benefit from the factor handling this function.

The Risks and Potential Drawbacks

While factoring is highly effective for improving liquidity, potential drawbacks must be considered:

1. Loss of Control over Customer Relationships

When you use disclosed factoring, the factor handles all communication regarding payment. If the factor is overly aggressive or lacks sensitivity during collection, it could damage the relationship between your business and your customer.

For UK businesses seeking guidance on dealing with collection or payment disputes, the government provides resources, such as information on resolving issues with unpaid commercial debt. You can find relevant guidance on commercial debt here.

2. High Costs Relative to Traditional Lending

Factoring can be more expensive than traditional bank loans or overdrafts, especially when factoring fees and interest rates are combined. If customers pay very slowly, the discount rate accrues over a longer period, increasing the overall cost.

3. Recourse vs. Non-Recourse Factoring

Most factoring facilities are recourse. This means if the factor fails to collect the debt because the customer goes bankrupt or refuses to pay (for reasons other than a genuine dispute), your business remains liable. You would have to buy the debt back from the factor.

Non-recourse factoring protects the business against customer insolvency, but it is typically more expensive and factors usually require significant due diligence on the debtor.

4. Credit Search Implications

When applying for factoring, the factor assesses the creditworthiness of both the debtor (the customer) and the business seeking finance. They also frequently assess the personal financial history of the company directors or partners before granting facility approval. Understanding your own credit profile is important when applying for finance. Get your free credit search here. It’s free for 30 days and costs £14.99 per month thereafter if you don’t cancel it. You can cancel at anytime. (Ad)

People also asked

Can small businesses use invoice factoring?

Yes, invoice factoring is highly popular among small and medium-sized enterprises (SMEs), particularly those that are B2B focused and experience long gaps between issuing invoices and receiving payment, as it alleviates immediate cash flow constraints effectively.

Is factoring considered a loan?

No, factoring is generally not classified as a loan because the business is selling an asset (the invoice debt) outright, rather than borrowing money that must be repaid. Invoice discounting, however, is closer to a secured loan since the business retains ownership of the debt.

What types of invoices can be factored?

Factoring companies typically only accept invoices related to completed goods or services delivered to other businesses (B2B). They generally will not factor invoices for individuals (B2C sales), services that are partially completed, or invoices that are already significantly overdue.

Does the customer know their invoice has been factored?

In standard invoice factoring, yes, the customer is fully aware, as the factoring company takes over the debt collection process and remits payment instructions. This is known as a ‘disclosed’ facility.

Is factoring regulated by the FCA?

While consumer finance is heavily regulated by the Financial Conduct Authority (FCA), commercial invoice factoring (B2B lending) is generally less regulated, though providers must comply with relevant commercial law and follow guidelines set by industry bodies.

Conclusion

Invoice factoring provides a vital service by converting illiquid assets (invoices) into immediate working capital. For UK businesses struggling with extended payment terms, it can be a strategic financial tool to maintain operational smoothness and fund growth without taking on traditional debt.

However, it requires careful consideration of the associated costs, the potential impact on customer relationships, and whether a recourse or non-recourse arrangement best suits the business’s risk profile. Consulting with a specialist finance broker or accountant is recommended to determine if factoring is the most cost-effective solution for your specific business needs.