Home » Business Advice » Invoice Factoring Explained

Invoice Factoring Explained

In 2017, 62% of invoices (with an average value of £51,826) issued by small and medium-sized enterprises (SMEs) were paid late. Payments were made anywhere from a few weeks to six months late and – perhaps surprisingly – larger companies were amongst the worst offenders when it came to late payments.

The Federation of Small Businesses estimates 25% of SMEs are at risk of failure due to the cash flow problems late payments create. This is especially true for business to business (B2B) enterprises, sole traders and start-ups, many of whom have to wait for invoices they’ve issued to be paid before they can pay the invoices they’ve received.

To help them manage their cash flow, companies might take out bank loans, use their overdraft facility or apply for invoice factoring.

What is invoice factoring?

Invoice factoring is a financial service that allows companies to borrow against unpaid invoices, which are used as collateral.

Tip: Invoice Factoring can be used as either a one-off or longer-term solution for managing cash flow as Invoice Factoring companies (lenders) set up accounts which you can use as and when needed.  

Who is eligible for invoice factoring?

Lenders have different eligibility requirements, which you’ll need to confirm with them.  In general, however, to be eligible for invoice factoring, your company will need to have:

  • An annual turnover of at least £25,000
  • Credit terms of no more than 90 days
  • UK-based business customers (B2B as opposed to consumers, B2C).

There are no exclusions as to the type of companies that can use invoice factoring, though it’s thought to work particularly well for sectors such as recruitment, food and hospitality, retail, wholesale and professional services.

Tip: While you may be eligible for invoice factoring, if you only have a few clients or don’t invoice on a regular basis, you might need to consider other options such as invoice discounting. 

The benefits of invoice factoring

One of the main benefits of invoice factoring is that once approved; you get immediate access to your cash.  Depending on the lender, this could be up to 95% of the value of your unpaid invoices, significantly reducing any cash flow pressures. And, because you’re using your invoices as collateral, the approval process is generally easier than getting approved for a bank loan.

Tip: While your invoices act as collateral when it comes to invoice financing, lenders still want to reduce the risk they won’t be paid back.  They might, therefore, carry out credit checks on your customers and not accept those with a poor credit rating. 

The downsides of invoice factoring

 For all the benefits of Invoice Factoring, there are also downsides.  The main one is the fees, which can be quite high.

The other is that you lose control of your invoices.  While this might seem an obvious statement, if you’ve spent time building up positive relationships with your customers there is a chance these could be damaged. This is especially true if the lender takes a hard line approach with chasing overdue payments. When these invoices aren’t paid, the lender can reserve the right to ask you to buy it back or replace it with another invoice of the same (or higher) value.

Tip: According to Lendingexpert.co.uk It’s important you understand the fees charged against your invoice factoring account.  Some lenders, for example, may charge fees for carrying out credit checks on customers or late fees when they pay invoices late. 

How to apply for invoice factoring

If you want to apply for Invoice Factoring, you’ll need to complete an application form in much the same way as you would for a loan or line of credit.  Then, you’ll be asked for a range of documents that allow the lender to assess your eligibility.  Each will have a different set of requirements.

However, in general, they’ll want to see an overview of your company or business plan, your accounts receivables aging report and be told about any liens against your invoices or your company (including tax liens).

Tip: If you feel invoice factoring is for you, the first thing you’ll need to do is find the right financial institution.  Look for one with clear and transparent processes and an easy to understand structure for fees and charges as well as a good reputation for customer service.

The invoice factoring process

Once you’ve been approved, invoice factoring works in the following way:

  1. You invoice your client
  2. You submit your invoice to the lender
  3. The lender verifies the invoices
  4. The lender pays you the agreed advance (this is generally between 80% – 95% of the total value)
  5. Your client pays the lender by the agreed payment date
  6. The lender pays you the remaining value of the invoice minus any fees

Tip: Remember, you don’t need to submit all your invoices to the lender. Calculate how much money you need to raise to cover any gaps in – or stabilise – your cash flow and submit invoices worth this amount.  This way, you can save yourself money on fees and charges. 

Invoice factoring fees

Generally, the financial institution will charge you a fee for setting up your invoice factoring account.  You may also be charged a:

  • Factor fee: Covers the costs of chasing customers who haven’t paid their debts; this is usually calculated as a percentage of the overall value of your invoices.
  • Discount fee: Covers the period of the advance between when you received the initial payment / submitted the invoice to the lender and when your customer paid their invoice; this can be up to 3% over the Bank of England base rate.
  • Management fee: Covers the cost of running your account; this is usually charged

Tip: Financial institutions may charge different rates depending on your credit rating, that of your customers, your annual turnover and the number of invoices you are likely to submit each month.  Make sure you understand these and factor them into any calculations before settling on a specific invoice factoring lender.