What is Invoice Factoring and How Does It Work?

Are you a company that invoices clients and wants to get outstanding payments quicker than expected? Invoice factoring can be the best approach for you.

Essentially, invoice factoring involves selling all your company's outstanding invoices to a third party. The factoring firm will pay you a fraction of the amount in advance. When that firm receives the remaining payment from the client, you will be paid the rest after a small fee deduction.

Factoring firms will be the best help if your business lacks funds and wishes to improvise its cash flows. As a result, your organization will be able to make progressive investments more frequently while maintaining a streamlined cash flow.

Let's find out everything there is to know about invoice factoring- accounts receivable or debt factoring- and how your business can benefit from it.

How Does Invoice Factoring Work?

If you are trying to make sense of factoring and want to learn how it works, we tell you that the process for it is fairly straightforward. Whereas invoicing process takes 30 to 90 days of period for a payment to be completed, factoring can help your business by providing partial payment in advance.

Every factoring transaction will involve three types of parties:

1. A Seller (The invoicing business)

2. Debtors (Invoiced clients)

3. & the Factor (A factoring firm)

Let's find out how invoice factoring works step-by-step:

Step 1: Your business provides goods or services to a client (Debtor).

Step 2: The client receives an invoice (account receivable) generated by your business.

Step 3: You sell the generated invoice to a factoring firm that sells pays you a certain amount of the invoice (generally 80-90%) in advance after verifying the validity of the invoice.

Step 4: The factoring firm receives the payment for the invoice from a debtor directly.

Step 5: After receiving payment from the debtor, the firm will pay the remaining invoice value to the seller with a minimum fee deduction (for example, 2%).

When Is Invoice Factoring Best Suitable For Your Company?

In case your business suffers from a lot of outstanding account receivables and thus has a bad cash flow, invoice factoring will be the best resource for you.

Suppose your business has issued an invoice to a client with a payment period of 30 days. At the same time, some clients will pay you for the issued invoice within the time, while others will require chasing.

You may lose occasional business opportunities with a low cash flow as your clients will not make payments on time. However, invoice factoring will save you from trouble by securing payments for your invoices in advance. With the help of this approach, your business will be able to:

Effectively deal with short-term expenses

Make payments for loans

Take advantage of seasonal deals

Or perform any business activities that may require a streamlined cash flow.

Advantages of factoring

Depending on your small business's needs and the factoring firm you choose to work with, factoring has a lot of advantages. Here, we'll outline the benefits so you can get the complete picture:

Easy payments for outstanding invoices

The most common problem that small businesses face is insufficient cash flow due to outstanding payments. At the same time, it is easier for a large-scale business to deploy a credit control team for payment collection purposes. Being a small business owner, it will not be a practical option for you.

Since the factoring company is entirely responsible for collecting client payments, this approach will relieve your small businesses of this time-consuming responsibility. With the help of a factoring firm, your business will be able to manage operations more successfully and profit from creating solid, lasting relationships with its clients.

Financing with no debt

The approach of factoring does not involve any additional debts for your business. As you will sell your company's invoices to a third-party factoring firm, there will no longer be any responsibility for payment collections on your end. Selling invoices also transfers the ownership to the factoring firm.

This is the particular reason that makes factoring an entirely debt-free financing approach. Your business will be able to get rid of unpaid invoices instantly from the balance sheet resulting in improved cash flows.

Quick and hassle-free approvals

The credibility of your clients is something factoring firms will be bothered about more than your company's credit score. Even though credit score is still an aspect that they will take into account, it is still not regarded as vigorously as banks do.

The conditions could be defined in line with your company's account receivables, including the amount customers owe you and their likelihood of paying you. Because of this, the approval procedure is typically quicker and less complicated. Make sure to pay attention to the seller and buyer requirements before you apply for factoring with a firm.

The bottom line

Overall, invoice factoring is a great approach to paying your clients for outstanding invoices quickly. This approach is easier to get started with, but the associated advantages are also considerable for small businesses struggling with lower cash flows. But, before deciding to pursue invoice factoring, be sure to balance out all of the benefits and drawbacks that will arise. If your company frequently deals with late invoice payments, this strategy may be a hassle for you. If not, you must immediately sign up with a reputable factoring company!