What it means
Many businesses sell on credit and then wait 30, 60 or 90 days to be paid. During that wait, wages and suppliers still need paying, so fast growth can squeeze cash even when the company is profitable.
Factoring closes the gap by bringing the money forward. In a typical arrangement the business sells its approved invoices to the factor.
The factor advances a percentage, often 70% to 90% of the face value, and holds the rest as a reserve. When the customer pays, the factor releases the reserve minus its fee.
The cost comes from a discount fee charged on the invoice value for the time it is outstanding, plus sometimes a service charge for collecting the debt. Because the fee is a small percentage of the invoice but is charged over a short period, the equivalent annual cost can be high.
Finance teams should always convert the fee into an annualised rate to compare it with a bank overdraft or loan. There are two main variants.
In recourse factoring the business must buy back any invoice that the customer fails to pay, so the credit risk stays with the business. In non-recourse factoring the factor accepts the risk of customer non-payment for approved debts, which costs more.
Notification also varies. In disclosed factoring the customer is told to pay the factor directly, while in confidential arrangements the business still collects the money and passes it on.
Invoice factoring is also not the same as invoice discounting, where the business keeps control of the sales ledger and customer relationship.
In practice
Real-world examples
Example 1
A staffing agency pays its temporary workers weekly but its corporate clients pay after 60 days. It factors its invoices each week so that payroll is covered. The cost is high, but it lets the agency take on bigger contracts without running out of cash.
Example 2
A garment manufacturer wins a large order from a department store. The order needs $200,000 of fabric up front, and the store will not pay for 90 days. The manufacturer factors the invoice as soon as the goods ship and uses the advance to start the next production run.
Example 3
A small trucking company factors each delivery invoice to pay for fuel and driver wages. The factor also checks the credit standing of the shippers before approving each invoice. This gives the owner an extra layer of protection against bad customers.
Think of it
Imagine you sold a bicycle to your neighbour for one hundred pounds, but they promised to pay you next month. You need money today to buy groceries, so your friend offers to buy that promise from you for ninety pounds right now. Your friend collects the hundred pounds from your neighbour later, keeping the ten pound difference as a fee for waiting.
Formula
Calculation
Cash received = Advance + (Reserve - Fees)
Annualised cost = (Fees / Advance) x (365 / Days outstanding)
A supplier factors $100,000 of invoices with an 80% advance, so it receives 100,000 x 0.80 = $80,000 on day one. The factor charges a fee of 3% of the invoice value, which is 100,000 x 0.03 = $3,000. The customer pays after 45 days and the factor releases the reserve of 100,000 - 80,000 = $20,000 less the fee, so the supplier gets 20,000 - 3,000 = $17,000. Total cash received is 80,000 + 17,000 = $97,000. The annualised cost is (3,000 / 80,000) x (365 / 45), which is 3.75% x 8.11 and works out at about 30.4% a year.Case study
Seen in the real world
Harbourlight Packaging is an illustrative, fictional manufacturer of food containers. It landed a contract with a national supermarket chain that paid on 75-day terms, and within six months its overdraft limit was fully used. The owner could not hire more staff without a way to bring the cash forward.
Harbourlight factored the supermarket invoices at an 85% advance and a fee of about 2.5% per invoice. The annualised cost was well above its bank rate, so the finance manager treated the arrangement as a temporary bridge. After a year of steady profit the company negotiated a larger bank facility and moved off factoring, having used it to survive its fastest growth phase.
Watch out
Common mistakes
- Looking only at the headline fee and ignoring that it is charged over a short period, so the annualised cost is far higher than it looks.
- Assuming the factor takes all the risk of non-payment, when many agreements are recourse and leave the business liable.
- Factoring every invoice by default instead of choosing only those where the cash timing really matters.
Questions
People also ask
Is invoice factoring a loan?
Not in the legal sense, because the business sells the invoices, but the accounting treatment depends on who keeps the risks and rewards of ownership.
Who collects the money from the customer?
In disclosed factoring the factor does, while in confidential factoring the business collects and passes the cash to the factor.
Can a business with poor credit use invoice factoring?
Often yes, because the factor mainly judges the creditworthiness of the customers who owe the invoices, not of the business selling them.