Invoice Factoring: Smart Financing or Risky Business?

Invoice "factoring" can get you paid fast, but it also poses special risks. Here's what you need to know to keep from getting burned when selling your unpaid invoices.

Resource Nation provides how-to purchasing guides, tips for selecting business service providers, and a free quote-comparison service that allows business owners to compare price and service offerings in over 100 categories from invoice factoring to business cash advances.

When credit markets tighten, businesses turn to alternative financing methods like invoice factoring or business cash advances -- at least according to the Commercial Finance Association (CFA), which has tracked asset-based lending trends over the past decade.

The CFA survey places the amount of outstanding asset-based loans at $600 billion for last year, a figure that has grown at a fairly rapid rate since the late 1970s. Factoring has become a trend within several industries recently, because it helps businesses get fast cash without the approval restrictions necessary for business loans or lines of credit from traditional lenders. And the transactions can even be lucrative for some companies.

Still, factoring can be risky business for companies. Armed with some basic information on factoring transactions, you can - decide if this method of alternative financing is right for your business.

What Is Factoring?
Though the transactions often operate in similar way, factoring isn't a loan -- it's technically a "sale" of accounts receivable or unpaid customer invoices to a "factor" or a factoring services provider. The factor takes the rights to collect on an invoice (called "assignment") in exchange for an up-front cash payment. It's a little like inventory financing in reverse -- instead of using an asset as collateral, a business uses debt (the customer's promise to pay) to secure funding. Factoring lets businesses convert unpaid invoices into cash more quickly than waiting for the customer to remit the full invoice balance.

Businesses that sell to customers on credit, those that have long billing intervals, or those with long product-purchase cycles are prime candidates for factoring. The factoring industry gets an overwhelming majority of its business from companies in industries like garment manufacturing, where the time between placing an order and receiving payment can run to months or more. In fact, many businesses that need cash for operational and production costs incurred before customer payment is actually made often use factoring as a primary method of short-term financing.

How Factoring Works
A factoring transaction starts out similarly to a loan -- with an application and approval process. Unlike traditional lenders, though, a factoring company isn't concerned with your business' credit history -- the creditworthiness of your clients (those whose invoices you "sell" to the factor) is their key concern. You may need to provide payment history records, invoice receipts, and other documents to show that the factoring company is assuming little risk in purchasing a specific invoice.

Most factoring business services offer online applications in which you detail the invoices to be assigned, the length of the repayment period, and other details. You can apply for an "open account," in which you have the option to transfer additional invoices later, or transact with the company on a one-time basis. Most factoring companies charge a setup fee to cover a credit check of the customer company -- if you choose an open account, you can avoid paying these charges multiple times.

Once you've been approved to transfer invoices, you'll sign a contract where you formally "assign" the right to collect on a bill to the factoring company in exchange for an "advance amount." The advance amount can be anywhere from half to 95% of the invoice value. Typically the remainder, less the factoring provider's fee, is paid when the customer pays the bill in full. For example, if you factor a $10,000 invoice for a $9,000 advance at a 5% rate, you'll get $9,000 when you sign the factoring agreement and another $500 when the customer pays up (The $1,000 balance less the 5% fee).

The benefit to this transaction is that your business gets the operating cash it needs -- right away. The downside, apart from the fee, is that an important customer service process -- collections -- has just been placed in the hands of an outside party. According to the CFA, the vast majority (78%) of these financing transactions are "notification" transactions, in which the business is required to notify the customer whose invoice has been assigned. Notifying your customers that you're selling your invoices can adversely impact your relationships. If customers think your business is facing financial or cash-flow problems, they might cut back on future orders or even discontinue doing business with your company entirely.

There's also the issue of the collection process itself, which the factoring business is able to take charge of. Factoring companies that harass customers for payment, are unresponsive to billing questions, or provide generally poor customer service can have a big impact on your ability to maintain positive customer relationships and gain repeat business.

Many of these practices can be safeguarded against by thoroughly vetting the factoring company you choose. Ask to see several examples of client correspondence, or visit the office one day to listen in on client phone calls, if possible. But beware. Just because a factoring company provides great service to you as it's trying to get you tell your invoices doesn't mean it will behave the same way once transactions are finalized. And it doesn't mean that they'll treat your customers that way, either. Make sure you do plenty of research, including asking for referrals.

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The Factoring Agreement: How To Get The Best Deal
Factoring transactions are governed by contracts, or factoring agreements. You can choose to "factor," or sell, a batch of invoices, an entire customer account, or several smaller invoices over the course of business with a factoring company.

Keep in mind that the rates you're charged (the factoring company's "cut" of the transaction) are determined not only by the creditworthiness of the clients, but also by the total invoice amount and payment due date. Factoring companies use their own formulas to determine rates, advance amounts, and approvals, which can vary from company to company.

These four things can impact the total cost of your transaction:

  1. Amount of Invoices: The higher the dollar amount of individual invoices, the better deal you're likelier to get. While you may not be able to negotiate on rates based on dollar amount alone, you will qualify for a significantly higher advance amount if you're able to assign invoices for $10,000 or more.
  2. Number of Invoices: Factoring services prefer to take on a few high-dollar invoices, as opposed to customer accounts with several small amount bills. Generally, the less labor-intensive the collection process, the better deal you'll get.
  3. Billing Method: Companies that use non-cumulative billing (for example, bills are sent for services already delivered) will be able to obtain better rates. Cumulative billing often requires ongoing interaction with the client (adding to the "tab" or open bill, etc.) and is more time consuming -- and less desirable -- for the factoring company.
  4. Recourse Factoring: Recourse factoring, where your business "guarantees" a customer invoice (you return the advance amount if a customer doesn't pay by the due date), is less risky for the factoring company, so it's less expensive in the short run. However, it is more risky for you -- it could end up being more costly overall if the customer doesn't pay as expected. You could even find your company is responsible for fees and penalties along with the repayment of the advance.

Before You Sign On The Dotted Line
In many ways, factoring is just like any other type of business financing -- you should choose the company that offers you the best rates, explains everything thoroughly, and provides great customer service. With so many factoring providers looking for business, it pays to shop around for competitive rates and compare specific contract terms before making your decision.

In particular, if your contract contains recourse provisions, requires you to pledge collateral, or specifies other penalties or costs in the event that the customer does not repay the factor, be sure to consider these potential costs as part of the "risk level" of the arrangement.

Though factoring can allow you to reap the benefits of a faster payment cycle, it also poses special risks. You're turning over your collections to a third party, and that could affect your reputation and your business relationships. Make sure you're absolutely confident the factor will treat yourr customers with respect, and make sure to read any and all contracts carefully -- or have your attorney read them -- before signing on the dotted line.

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Resource Nation provides how-to purchasing guides, tips for selecting business service providers, and a free quote-comparison service that allows business owners to compare price and service offerings in over 100 categories from invoice factoring to business cash advances.

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