What Is Invoice Factoring And How Does It Work?

Invoice factoring, also known as accounts receivable financing, is a financial solution that allows businesses to convert 70 percent to 90 percent of unpaid invoices into immediate cash. Its main draw is that it improves cash flow, but businesses can also appreciate that it reduces the burden of collections and helps maintain the healthy working capital necessary for business growth.

We’ll explore the ins and outs of invoice factoring to help you decide if its potential benefits make it a good fit for your business needs.

What is invoice factoring?

Invoice factoring is a short-term alternative financing option for businesses that send invoices to customers.

Businesses can sell their outstanding invoices to an invoice factoring company. The factoring company pays most of the invoice’s value upfront and takes on the responsibility of collecting the invoice from the client. 

This allows businesses to receive money from invoices earlier than they normally would, as invoices often take between 30 and 90 days to be paid.Companies can use the money from invoice factoring for whatever they need. 

Once the client pays the invoice, the invoice factoring company will take out their fees and interest and then pay the business  any remaining funds they are owed.

Invoice factoring is suitable for businesses that may not qualify for a traditional business loan due to not meeting the typical loan requirements. Factoring doesn’t require good credit or a traditional loan application process from the business.

What is a factoring company?

An invoice factoring company is any company that offers invoice factoring to businesses. Most major banks and credit unions don’t offer this financing option, so you’ll usually find invoice factoring from online lenders that specialize in factoring. The factoring company is responsible for collecting invoices directly from your customers, so you’ll want to work with a reputable company.

Is invoice factoring a loan?

While often lumped in with loan options, invoice factoring isn’t technically a loan. When you sign on to work with a factoring company, they pay you for the invoice and take on the responsibility of collecting payment from the client.

Also unlike a loan, the factoring company will look at your clients’ creditworthiness instead of your business’s to determine if they will work with you. This lenient approval process allows businesses to be accepted even if they wouldn’t qualify with a traditional lender.

While invoice factoring isn’t the most popular type of loan, according to the 2024 Small Business Credit Survey, 2 percent of employer-based businesses used factoring on a regular basis, making it an important part of their operations.

How does invoice factoring work?

The invoice factoring process involves three key parties: the business (you), the client you are invoicing and the invoice factoring company.

Basically, the factoring company provides immediate cash, based on a percentage of the invoice value, to the business and collects payment from the customer directly.

Invoice factoring works in a few straightforward steps:

1. You complete work for the client and send an invoice.
2. The invoice factoring company vets the client for creditworthiness.
3. If the invoice factoring company approves the client, they will advance you 70 percent to 90 percent of the invoice value.
4. The client pays the invoice factoring company directly.
5. The invoice factoring company takes out any fees and interest and sends you the remaining amount you are owed from the invoice.

Here’s an example of what this might look like:

Cost of invoice factoring

You will be responsible for the fees associated with invoice factoring, which the invoice factoring company will automatically deduct from the client’s payment. Some invoice factoring companies may have hidden fees, so read the fine print before signing an agreement with an invoice factoring company.

These are fees the invoice factoring company may charge you:

• Interest: Typically 0.5 percent to 4 percent. This may be a one-time fee or may accumulate weekly or monthly while the invoices go unpaid.
• Late payment fee: Charged if a client pays the invoice after the due date.
• Returned check fee: Charged if the client’s check bounces.
• Wire transfer fee: Charged by some companies if the client pays by wire transfer.
• Origination fee: Sometimes charged when you start a contract with a factoring company.
• Termination fee: Sometimes charged when you end your contract with the factoring company

Bankrate insight

Yes, invoice factoring will affect your taxes in two ways. First, since you’re selling the invoices to the factoring company, you will need to report the sale as income to your business. You will have to pay taxes on this income.

Second, you can deduct the factoring company’s fee as a business expense, which will effectively lower how much you pay in taxes that year. Consider these tax implications before signing the invoice factoring agreement. You’ll want to consult a tax professional to ensure that you’re properly reporting this income and expense on your business taxes.

Types of invoice factoring

In business, there’s always a chance that your customers won’t make good on their invoices. Invoice factoring can either offer recourse or no-recourse financing, which will affect your responsibility for paying back the advance if your customers don’t pay you. 

• Recourse factoring puts the weight of responsibility to repay the factoring company on you. If your clients don’t pay the invoice, you will buy back the invoice and pay it out of other business revenue or assets. This is the most common type of invoice factoring.
• Non-recourse factoring puts the weight of responsibility on the factoring company. If the customer doesn’t pay, the factoring company will have to file the collection as a loss.

Consider whether your business can take on the risk of recourse factoring before using invoice factoring services. Note that it’s common for any business loan to require you to pay the loan in full even if your revenue dips and you can’t make loan repayments.

Invoice factoring vs. invoice financing

Invoice factoring and invoice financing are two different ways to receive the funds for an invoice before a client pays.

Invoice factoring works by allowing the factoring company to directly reach out to the business’s clients to collect invoices. On the other hand, invoice financing works like a traditional loan, allowing the business to collect its own invoices from its clients. Instead, invoice financing uses the invoice as collateral for the loan.

The choice between invoice factoring or financing will depend on how involved you want the factoring company to be in collecting the invoices.

Invoice factoring pros and cons

Invoice factoring can be a great option if you need money for your business quickly. However, it’s not always the right option. Here are the pros and cons of invoice factoring for you to consider.

When should you use invoice factoring?

Invoice factoring is an alternative to a business loan, and there are some instances when you might choose this option or go with another business loan. When to consider invoice factoring:

• You need fast cash. Factoring companies may be able to approve and give you funding within a few days. Invoice factoring works well if you need quick cash to cover a purchase or take advantage of a time-sensitive opportunity.
• You can’t wait for outstanding invoices to be paid. You might choose invoice factoring if you need money to cover operating expenses or short-term purchases and can’t wait the usual 30 to 90 days to receive payment.
• You don’t qualify for traditional business loans. Other business loans typically offer lower interest rates and fees, and some lenders like online lenders can fund quickly. Because of the lower borrowing cost, traditional business loans are the better option if you can qualify. However, in some cases, you may need invoice factoring if you don’t qualify for a conventional loan.
• You can afford higher fees. If the benefits of using invoice factoring outweigh the downside of its high fees, you can choose this financing option. Just be sure that you understand the full cost of borrowing when you sign the agreement. If in doubt, ask the factoring company to explain its fee structure so that you have a full understanding of what you’re paying.

How to choose the best invoice factoring company

The best invoice factoring companies will offer the funding amount you need with reasonable terms and fees. Consider how different lenders compare when considering these factors:

• Industry: It can be beneficial to work with an invoice factoring company familiar with your industry and its challenges.
• Advance rate: Consider how much funding the lender will provide and how much you need to cover your purchase, such as 70 percent of the invoice amount.
• Factoring fee: Consider how much the factoring fee is and whether the fee increases the longer your clients don’t pay you. Opt for factoring companies with the lowest fees, and consider additional fees the company may charge such as administrative or origination fees. Funding time: If you need funding fast, you want to choose a company that can get you funds within the required timeframe.

Invoice factoring alternatives

If you decide invoice factoring isn’t the right option for your business, there are other options to consider.

• Invoice financing: Invoice financing is another way to get advance funding for your business. It still uses your unpaid invoices as collateral for the loan, but you maintain control over collecting the invoices from your client.
• Business loan: A conventional business loan from a bank or online lender can offer higher loan amounts and low interest rates. If you qualify, you’ll likely pay less in borrowing costs than you would with invoice factoring.
• Business line of credit: If you’d like consistent access to cash, consider a business line of credit. You can use as much (or as little) of your credit  limit as you wish, and you only pay interest on the amount you withdraw. Then, as you pay down your loan, you have access to that credit limit  again to borrow from in the future.
• Upgrade your invoice management: You may be able to avoid invoice factoring just by upgrading your invoice management process. Invoicing software can make it easy for you to quickly track your invoices and send automated reminders before payments are due. Autopay and online payment methods can make the payment process easy for clients and encourage on-time payments.
• Grants: Grants offer businesses funding that doesn’t need to be repaid. This is appealing to many business owners because there’s no risk of defaulting on a loan and no fees or credit checks. However, it is a more competitive funding option to pursue, so you’re not guaranteed to receive funding.
• Business credit cards: If you want to improve cash flow while building business credit, a business credit card is a good option. Depending on the card, you could earn rewards and perks on purchases. Also, if you don’t carry a balance month to month, you can avoid paying interest.
• Merchant cash advance: A merchant cash advance is another alternative lending option where businesses receive an advance of their future revenue. . With this option, you repay the amount borrowed automatically through a percentage of your credit or debit card sales. Like invoice factoring, this also allows quick access to funds for various business needs. However, interest rates and fees for MCAs can be exorbitant and come with aggressive daily or weekly payments. You may want to use this option for emergency situations.

The bottom line

If you’re looking for a fast way to maintain working capital and your company issues invoices, invoice factoring may be a good option for your small business. But, before working with an invoice factoring company, it’s important to understand how invoice factoring works and the fees you’ll be responsible for so that you don’t run into any surprises when repaying the advance.

Frequently asked questions about invoice factoring