Factoring is a type of financial transaction in which a company sells its accounts receivable (invoices) to a third party at a discount. In other words, it works by the company receives a cash payment upfront for the full value of the invoice, minus a fee.
The fee is typically a percentage of the invoice value, and it covers the factor’s risk in case the customer does not pay. For example, if an invoice is for £100 and the factor’s fee is 3%, the company will receive £97 in cash upfront. The factor then assumes responsibility for collecting payment from the customer.
This type of arrangement can be beneficial for businesses because it allows them to receive cash immediately, instead of waiting for customers to pay their invoices.
How does the process of factoring work
The invoice factoring process means that a business will sell the control of its accounts receivables, this can be done in part or in full.
The process works like this:
You provide goods or services to your customers in the normal way.
You raise an invoice for your customers for those goods or services.
You “sell” the raised invoices to a factoring company. The factoring company pays you the bulk of the invoiced amount immediately, typically up to 80-90% of the value, after verifying that the invoices are valid.
Your customers pay the factoring company directly. The factoring company chases invoice payment if necessary.
The factoring company pays you the remaining invoice amount – minus their fee – once they’ve been paid in full.
What are the steps involved in factoring transactions
The steps involved in factoring transactions are as follows:
Step 1: Find a factoring company
Factoring companies tend to specialise in specific industries. It’s best to choose a factoring company that has experience in your industry and is use to dealing with your size of business..
Step 2: Application and due diligence
The next step once you have found a factoring company is to complete and submit their financing application. Each factor has its own application process, though they are all similar. Factoring companies will need the application to evaluate your sales transactions as well as determine if it’s a good fit for both parties. During the due diligence process the factors will evaluate that your:
- Customers have good credit
- There is no pre-invoicing
- There is no underlaying problems with the company
The due diligence process only lasts a day this is sometimes referred to an an audit.
Step 3: Proposal and contract
Once the factor has completed their audit, you will receive an offer by the lender, the offer has the three key pieces of information:
- Advance rate
- Factoring rate
- Length of term
Step 4: Initial account setup
In this step, the factoring company sends Assignment Notices to every customer whose invoices you want to factor. The notice of assignment is a standard industry document and is used by every factor. It advises the customer’s accounts payable department how to handle future invoice payments. This process is make customers aware where to send payment to.
Step 5: Funding invoices
The funding of invoices is the submission process. You submit the invoices you want to finance through an online portal or by email to the lender. Once the factor has received the invoices they will verifies the invoices, then deposit the first instalment known as an advance in to your bank account. You simply repeat this step every time you want to finance invoices.
Step 6: Settling transactions
The lender will settle each transaction when your customers pay their invoices. Once paid, the factor remits the remaining 20% (less the fee) to you, this is the second instalment. This deposit will settle the transaction.
Step 7: Non payment of a invoice
Should you customer fail to pay the factoring company after 90 days from the issue of the invoice date, the said invoice will recourse, which mean any money advanced will be with drawn.
How does Invoice Factoring Work
Invoice factoring works by providing businesses with a way to convert their outstanding invoices into immediate cash. The process involves a few key steps. First, a business sells its invoices to a factoring company at a discounted rate. This allows the business to receive a significant portion of the invoice value upfront, which helps improve cash flow. Next, the factoring company takes over the responsibility of collecting payment from the customers.
They handle the invoicing and follow-up with customers to ensure timely payment. Once the customers pay the invoices, the factoring company deducts its fees and remits the remaining balance to the business. This arrangement enables businesses to access working capital quickly, without having to wait for customer payments.
It also helps them avoid the challenges of managing accounts receivable and the risks associated with late or non-payment. Overall, invoice factoring works as a valuable financial tool that provides businesses with the cash they need to operate and grow effectively.
Seasoned professional with a strong passion for the world of business finance. With over twenty years of dedicated experience in the field, my journey into the world of business finance began with a relentless curiosity for understanding the intricate workings of financial systems.