How invoice factoring works and mistakes to avoid
Invoice factoring basics
- A business can sell invoices for completed services or delivered goods to a third party, known as a factor.
- Invoice factors carefully evaluate a business when setting up an arrangement.
- Companies must file invoices in a timely manner and ensure these are for completed or delivered services.
- Companies can be charged hidden fees and penalties, so read the fine print.
Businesses often don’t want to wait for up to two months to get paid by customers for the goods and services that they provide, so they choose to sell their invoices to a third party.
This is known as invoice factoring. Factoring is an age-old practice, and today many companies make use of it to generate a more predictable cash flow. Invoice factoring is often used by companies in the construction, medical and transportation fields, for example.
Invoice factoring is a good way for a small business to maintain cash flow to fund the daily operations of a company. Cash-flow problems are a major cause of business failures.
How factoring works
After setting up an account, the business will send its invoices for completed goods and services to the factoring company. In turn, the factoring company will verify that the invoice is valid and will then pay a certain amount upfront almost immediately to the business.
That factoring company usually holds back a reserve amount, which is released at a later time. The factoring company earns its income by taking a percentage of the invoice amount, usually somewhere in the range of 1 percent to 5 percent.
The terms of an invoice factoring arrangement can depend on the company’s size, credit history and stability. The factoring company will typically want to know a lot about a company’s business, and its anticipated revenues and expenses. When preparing an application, a business needs to provide detailed and accurate financial information to the factor. Mistakes can lead to unfavorable factoring terms or even a denial of the application.
Another mistake made by some companies is sending invoices for undelivered services — such as a bill for a contracted service that has not yet been performed. Only invoices for completed services or delivered goods can be factored.
Companies sometimes also fail to provide receipts and other supporting documentation for the invoices, or send the invoices late. This can lead to payment denials.
A business should also thoroughly understand the arrangement with the factoring company. Today, most invoice factoring deals are nonrecourse, meaning that if a customer defaults on the invoice, the factoring company will not come back and demand payment for the uncollected amount.
Usually the factoring company is covered by insurance for any defaulted invoices. Some factoring arrangements, however, are considered recourse arrangements, which mean that a business that was paid upfront for an invoice could be liable to repay the factoring company for the uncollected balance of the invoice.
Factoring companies also sometimes charge hidden fees and penalties. The factoring arrangement, for example, can establish a minimum invoice volume. A business could be charged a fee if it doesn’t hit the minimum target specified in the arrangement. It is important that companies read the fine print carefully in any factoring agreement.