What Is Invoice Factoring & How Does It Work?

Gain a fundamental understanding of invoice factoring.

Updated: June 13, 2024
Matt Crabtree

Written By

Matt Crabtree

Rebecca Goodman

Edited By

Rebecca Goodman

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Whether you're managing a large or small business, the way you handle your cash flow can make or break your company's success.

Having said that, smaller businesses can face cash flow challenges more frequently than large ones, as they tend to have smaller overall profits and reserves to fall back on.

One option if you're facing financial problems and worried about insolvency is invoice factoring.

In this article, we're going cover what invoice factoring is, how it works, its benefits, and more generally how it works within the UK business ecosystem.

The basics of invoice factoring

To kick things off, let's start with some basics of how invoice factoring works and when you might need to use it.

In essence, invoice factoring is basically just a financial transaction where your business sells any of the outstanding invoices you've got to a third party, known as a factoring company, instead of dealing with them yourself. It can be used by any size businesses, but if you have a small business – there are around 5 million of them in the UK – you may be more likely to experience cash flow issues.

The aim here is mainly to receive an instant cash injection for your business as you will be paid immediately by the factoring company rather than having to wait for your customers to settle their invoices.

Still, you won't get given the entire value of the invoice at once — the company will generally pay you a percentage of the total invoice, usually around 80% to 90%. Then, once your customer has settled the invoice, the remainder will be paid to you, minus a fee.

How does invoice factoring work?

Invoice factoring is for businesses so to start with, you'll be providing goods or services to customers, and there will be a cash flow issue with late invoices.

At his point, your business can opt to sell the invoices to a factoring company, who will send you a percentage of the total invoice value within around 24 hours.

The factoring company will deduct any fees and transfer the remaining balance to your business once the customer pays the full invoice amount, so you don't have to deal with the customer.

What's the difference between invoice factoring and invoice discounting?

At this point, it's worth bringing up another phrase that's used fairly interchangeably alongside invoice factoring — invoice discounting. There are definitely similarities between the two, but they have vastly different implications for your business.

Each of these methods involves using unpaid invoices to secure funds, but that's more or less where the similarities end.

Put simply, invoice factoring gives all control over credit management and customer payments to a factoring company, whereas invoice discounting allows your business to maintain more control over these aspects.

The role of invoice financing providers

Invoice factoring services are usually provided by a specialised institution known as invoice finance providers, and they're the ones responsible for providing the solutions to anyone looking to leverage their accounts in order to improve their cash flow.

Having said that, not every invoice finance provider offers the same standard of service — whether it's slightly higher fees, advancing you a lower percentage of the invoice amount, or how they act with your customers.

That's why it's important that you choose an invoice finance provider that's both reputable and has a track record of working with companies within your industry.

The role of invoice factoring companies

Factoring companies are going to play a pretty key role in the overall invoice factoring process, since they're the ones who purchase all the unpaid invoices from your business in exchange for immediate funds.

Most reputable companies will be well-versed in credit control and managing customer payments (obviously, the extent of which depends on the standard of provider you find), as this is what you're paying them to do, leaving you to get back to the day-to-day handling of your company.

Advantages of invoice factoring

The major benefit is the ability to receive instant cash when your business might be financially struggling to pay bills or employees is something that can rescue your company from the brink of insolvency.

You'd be hard-pressed to find a loan provider that can provide you with 80-90% of your expected revenue within a day or so.

Even if it's not for emergency reasons, you can also opt for invoice factoring just so that you have some extra liquidity to invest in any kind of growth opportunities that might come your way.

Being able to transfer all of your credit responsibilities to the factoring company is also a nice way of improving your overall efficiency, since it's no longer you who has to chase after customers for payments.

However, it's worth keeping in mind that there is a fee for using these services – and there are pros and cons to weigh up.

How much does invoice factoring cost?

It's important to be aware of all the associated costs that come with this kind of service, which is usually in the form of a discount fee (which is a percentage of the total invoice value) and possibly service charges.

In general, there are usually quite a few variables that can influence invoice factoring costs, with things like your business's creditworthiness, the industry that you operate in, and the volume of invoices that you need to be factored.

Not every small business is going to be able to afford some of these costs, so you'll have to work out whether you can take the knock to your total revenue in exchange for immediate liquidity or if you're better off waiting for your customer's payments to come through.

Having said that, if you're in a fairly desperate state and are willing to take the sacrifice, invoice factoring could be a good option, just aim to address the core reasons for any cash flow problems you're experiencing as quickly as possible.

Related Guides:


Can Businesses in Any Industry Use Invoice Factoring?

How Quickly Can a Business Receive Funds Through Invoice Factoring?

Are There Restrictions on the Size or Number of Invoices a Business Can Factor?

How Does Recourse and Non-Recourse Factoring Differ?

Can Businesses Choose Which Invoices to Factor?

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