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What is Factoring? Your Ultimate Guide to Understanding Invoice Factoring

Businesses pursue funding for several reasons, such as an expansion, a slow season, hiring new staff, etc. One of the lesser-known ways to finance your expenditures is factoring, also known as invoice factoring. If you’re wondering, “what is factoring,” don’t worry. You're not alone. 

Many business owners are unfamiliar with or have less knowledge about factoring than other funding options like small business loans or working capital loans. We’ve got you covered. This article discusses everything you need to know about factoring, so you can make the best decision for your business. 

What is a Factor?

A factor is a company that provides capital to businesses in exchange for unpaid invoices. More commonly known as a factoring company, a factor will almost always be a lending institution like Midwest Business Funding. 

This can sometimes be confusing because many people think of a factor as an element or component of something, but in business finance, the factor is the lending institution.

Why Would a Business Need Business Invoice Factoring? 

As a business owner, you may have several clients or customers on different payment schedules. Some of your customers pay on time, every time, and that’s great! But you may offer some customers the ability to pay 30 or even 60 days after the invoice date, known as a net 30 payment or net 60 payment. This is common practice in the business world. 

Imagine this scenario. You have bills due — and, unfortunately, you do not have 30 additional days to pay. To make matters worse, your customers that normally pay on time have to pay late this month. You just paid payroll and don’t have enough to make the payment you need to. 

Scenarios like this — and others — are when invoice factoring becomes very handy. Factoring works faster than most other funding options, and there are no long-term commitments. 

How Does Invoice Factoring Work? 

To benefit from factoring, you must have at least one outstanding invoice. Unpaid invoices can lead to cash flow issues, especially if you have bills to pay that cannot wait another 30 days. 

This is how factoring works. You apply for invoice factoring with a lender like Midwest Business Funding, and once approved, you’ll get most of the cash up front and the remainder once the invoice has been collected, minus a fee. Lenders treat this transaction as an asset sale. In essence, you are selling your rights to your invoice. 

When you sell your unpaid invoices to a factoring company for an immediate cash payment, it's typically anywhere from 70% to 90% of the total value of the invoices. It's now the responsibility of the factoring company to collect the payments. 

A Factoring Example

Let’s say you have five unpaid invoices totaling $30,000, and a factor agrees to purchase your invoices. The factor states that the fee will be 3%, or $900, and they advance 85%. You would receive $24,735 (85% of the invoice total after the fee deduction) immediately and the remaining $4,365 once the clients pay the factoring company.

Since the invoice is the collateral, it is much easier to qualify for factoring than a traditional loan or line of credit. 

Types of Factoring

There are essentially two types of factoring, full recourse, and non-recourse. 

  • Full recourse invoice factoring: If you agree to full recourse factoring, the factoring company can sell the invoice back to you if your client does not pay within 90 days. Just be aware of that; the invoice may come back to you. 
  • Non-recourse factoring: A non-recourse factoring agreement means that if the client does not pay the invoice after 90 days, the factor cannot sell the invoice back to you if the issue is due to a credit problem.

    There is some confusion around this because many companies define the “credit problem” differently. Often, it’s defined as declared bankruptcy, but it varies from institution to institution. So, depending on the situation, you may still be required to buy the invoice back after 90 days if your customer doesn’t pay the factoring company. 

Pros and Cons of Factoring 

As with all types of small business financing, there are benefits and downsides to invoice factoring. Understanding the pros and cons can help you decide if factoring may be a good fit for your business. 

Pros of Invoice Factoring

  • Provides near-immediate access to cash for the business 
  • Improves cash flow and working capital 
  • Easy to apply for 
  • Invoice acts as collateral 

Cons of Factoring

  • Deposits split into two payments 
  • Fees can be between 1% and 5% of the value of the invoice 
  • Some factoring companies closely examine your financial statements 
  • Enables 3rd party access to your customers 

Typical Factoring Advance Rates 

As previously mentioned, a factor will pay cash upfront for a certain percentage of the invoice total. The amount that a factoring company will advance generally depends on your industry. While the exact advance amount varies from factor to factor, here are common factor advances by industry.

  • Construction: 70% to 80%
  • B2B Business: 70% to 85%
  • Medical Billing: 60% to 80% 
  • Trucking: 85% to 95% 
  • Staffing: 85% to 93% 
  • General: 70% to 85%

Typical fees range from 1.15% to 4.5%, depending on the factoring company. Always ensure you understand the terms and conditions of your factoring agreement before signing.  

How to Choose a Factoring Company 

By now, you likely have an idea if factoring is a viable option for your business, but how do you choose the right factoring company? It’s always a good idea to compare your options and select the lender that makes the most sense. Here are some considerations: 

  • The types of businesses the factoring company typically lends to 
  • The advance percentage 
  • The factoring fee
  • The reputation of the lender
  • The amount of personal touch they offer
  • The application process 

Business funding should be more than signing a contract. At Midwest Business Funding, we believe a partnership is the best approach. We believe that you deserve a personalized touch from a lender that actually listens to your concerns, goals, and financial needs. 

If you believe invoice factoring is a good option for you, give us a call today.