Invoice factoring is an established form of business lending that can help certain SMEs by offering a reliable payment cycle and a better management of their cash flow requirements. Invoice factoring enables businesses to convert their accounts receivable into immediate cash, rather than having to wait to receive payment. This form of funding can be much simpler and quicker to secure than other types of long-term lending, which often require rigorous application processes.
How invoice factoring works
On issuing an invoice to its client (usually payable within 90 days) the SME immediately “sells” the invoice to a factoring company in exchange for an upfront advance of about 80 per cent of the invoice’s value.
The factoring company then assumes responsibility for collecting the payment from the SME’s client. Once the client pays the invoice, the factoring company makes a second payment to the SME of the outstanding 20 per cent balance, less any fees.
This transaction benefits both sides. In receiving the upfront advance on issuing an invoice, the SME receives the bulk of the funds it is expecting immediately. It does not have to wait for its client to pay it. If the client defaults then the SME has also managed its exposure to this, by transferring responsibility for collection to the factoring company.
Assuming it manages its selection process appropriately, the default risk to the factoring company should be minimal. As such it is able to deploy its capital in a relatively secure manner, generating its return via the fees it charges once the invoice is settled.
Who invoice factoring works best for
Invoice factoring is best suited to companies that have a reliable payment cycle and whose clients are well established. This typically means businesses that supply products or services to other larger companies or governmental organisations.
When deciding whether to accept a client’s invoices for factoring, the factoring company will typically assess the creditworthiness of the invoice recipient. This can be especially helpful for smaller suppliers as it means they can benefit from their customers’ credit rating, without having to go through a credit scoring process directly.
This process is especially for beneficial for SMEs whose business models are predicated on a higher proportion of upfront costs. The most common examples of this are those companies that employ staff to deliver their services or create their products. These companies often have a large monthly payroll cost to cover, so waiting up to 90 days before receiving payment for issued invoices can create cash flow problems.
However, for a factoring company, which does not have such monthly payment commitments and usually has access to greater working capital, the gap in the time it can take for an invoice to be paid is less of a potential issue.