Invoice Factoring: An Ultimate Guide for Small Business Invoice Factoring

Ezra Cabrera | August 19, 2022


    You've probably considered or heard about invoice factoring if you own a small business with slow-paying customers or occasionally limited cash flow.

    Invoice factoring for small businesses is a sort of accounts receivable finance in which you sell your unpaid invoices to a factoring company for a discount. You'll get lump cash to cover urgent company demands, as well as the required revenue to keep the doors open. Invoice factoring is a financing mechanism in which a company sells its invoices or accounts receivables to a factoring firm. The factoring business then distributes the remaining amount, minus a factoring charge, when the client pays for the products they got. Invoice factoring enables a small firm to get cash immediately after making a transaction, even if the customer has promised to pay later. 

    You've probably heard of invoice factoring or discounting, but both are ways to get money from an overdue invoice. They directly collect money from your clients when you sell your outstanding bills to an invoice factoring provider. The credit history of your consumers is used to determine factoring acceptance. Factors will assess your clients' financial status to assess risk. 

    The amount and value of invoices committed are within the authority of the business owner. Factoring can be an excellent alternative to loans for small businesses. Instead of negotiating with banks or lenders, small business owners can engage with a factoring company to get cash by "factoring" overdue invoices. Businesses may use invoice factoring to sell their outstanding bills and rapidly obtain additional financing. 

    How Invoice Factoring Works

    Here is how Invoice Factoring works for your business.

    Invoice your customer

    You send an invoice to your customer after you've given them goods or services. The customer must make these bills payable within 90 days to qualify for invoice factoring.

    Sell the invoice and assign it to a factoring company

    You must first identify a partner you want to cooperate with and complete the application before receiving invoice factoring financing. If you meet the factoring company's eligibility conditions, you will receive funding. It will also perform due diligence on your billed customers to determine whether or not they are good at credit risks.

    A factoring company will provide you cash in exchange for a cash advance on your invoice

    The factoring company pays you an upfront deposit based on a predetermined advance rate once you have submitted your invoices. The advance rate also referred to as the borrowing base, is typically 80 percent. You will determine your advance by the size of your trade, industry, as well as other risk factors.

    The Factoring firm receives payment from the customer

    Your client will pay the factoring provider as per the terms of the invoice. According to the Federal Assignment of Claims Act, the factoring company will manage the collection of all bills you allocate to it. Unless such a client is way overdue, it will follow your previous collection strategies.

    The Remainder, minus Fees, is sent by the Factoring Company

    The factoring business will provide you the outstanding balance of the invoice, termed as the reserve amount, after taking payment from your customer, minus its charges. The factoring business pays you the additional 17% of your advance rate of 80% and your regular factor rate of 3%, and your client settles within 30 days.

    How Invoice Factoring Improve the Business' Cash Flow

    Cash flow management is critical to the long-term success of any firm, large or small. Your cash inflows should exceed your cash outflows, mainly in the ideal case. 

    These are ways on how Invoice Factoring can improve Cash Flows:

    Cash on the spot

    Just after shipment, delivery, and invoicing of a client, you might receive an immediate cash payment. If you already have a partnership with a factor, selling receivables must only take approximately 24 hours. When purchasing invoices for the first time from a company, elements typically take up to two weeks to examine the consumers' credit ratings and convey reduced pricing.


    Factoring is selling assets, mainly invoices, rather than a loan. Factoring is an excellent alternative to debt funding for businesses that will either not qualify for standard bank loans or do not want to take on additional debt.

    Eliminated Collections

    The majority of factoring is "non-recourse," which means that the factoring firm buys all rights to the invoices, and the sellers have no collection responsibility. The expected collection costs and duration factors are the debtors' discounted buying prices. However, "right of appeal" factoring is legal in some countries. You are partly liable for any invoices not collected when using recourse factoring. Although the factoring business handles debt recovery, you are ultimately accountable for any percentage of the cash price linked to an unrecovered account.

    How to qualify for invoice factoring

    Many of the advantages of a line of credit can be obtained through factoring plans. They are, however, much likely to qualify for than traditional financing. To qualify, most factoring firms have pretty simple requirements. The list consists of the essential requirements for invoice factoring.

    1. You must run a business

    Only businesses can be financed by factoring industries. The majority of factors recommend that your company be formalized. Your firm should be organized as a corporation (Inc.) or a limited liability company (LLC). This requirement enables factors to distinguish between personal and business assets easily.

    2. Your company must have commercial or government clients

    Factoring plans offer financing by allowing you to sell your receivables to a factoring firm. Factors will only purchase your invoices if your clients are commercial businesses or government units. Sadly, factoring firms are unable to buy low-quality invoices. These should be directed to a lawyer or collections professional. It should be noted that factoring firms cannot purchase invoices owed by retail customers.

    3. Your client's commercial credit must be in good standing

    The most significant advantage of factoring is that it raises funds based on the creditworthiness of your invoices. Factors will only fund high-quality invoices that are almost certain to be paid on time. Factoring firms assess the creditworthiness of your invoices by examining your clients' commercial credit. Invoices from the state and federal governments are claimed to be in good standing. There are, however, some exemptions that vary by factoring companies.

    4. Your profit margins must be more significant than 10% to 15%

    Factoring is most effective if your profit margins are relatively high. Profit margins of 10% to 15% work well for giant corporations. A margin of 15% or more outcomes best for smaller businesses.

    5. Liens and encumbrances must be removed from your invoices

    Only invoices that have not been pledged as collateral to other institutions can be financed. Remember that when providing any funding, financing institutions are likely to file an "all assets" lien. These liens encumber your invoices.

    6. If you have tax issues or a tax lien, you should have a payment plan in place

    Under certain conditions, factoring businesses can finance invoices that are encumbered by a tax lien:

    • It would be best if you had a payment plan in place.
    • The taxing authority must be prepared to give up its receivables position.
    • Otherwise, your company can quickly charge the liability, and the lien will be removed.

    7. You should not be in the process of filing for bankruptcy

    While some factors provide bankruptcy financing (for example, a debtor in possession financing), it is a costly and complex solution. Most factoring firms will only finance businesses that do not have any active bankruptcies.

    8. Your personal history must demonstrate that you have great character

    Factoring firms conduct background checks as part of the underwriting process. They do not anticipate their clients to have a flawless background. They must, however, make sure that there are no serious problems. These decisions are made differently by each factoring firm.

    9. You should be capable of providing information about the company

    While your customers' credit is an essential parameter for a factoring firm, it is not the only one. Your business should be able to provide general information. Some requirements differ depending on the industry, but here is an overall list:

    • Identification from the government
    • Incorporation articles (or similar document)
    • Report on Accounts Receivable Aging
    • Relevant data on payroll taxes (if you have employees)

    It should be noted that each factoring firm is unique and has its own set of requirements. On the other hand, this guide should give a better idea of what you need to apply for an invoice factoring line.

    Final Thoughts

    For many small business owners, factoring is an appealing option since the factoring firm takes care of collections, allowing you to focus on your core business. If you're having trouble collecting from clients who aren't paying you on time and you don't know what else to do, factoring may be a wise option since it transfers that duty to a third party who is familiar with collections. 

    Factoring invoices is essential since it is a financial strategy that allows firms to get paid faster for work that has already been completed. Suppose you discover that cash flow gaps caused by sluggish customer payments limit your company's development or operations. In that case, you may believe that the solution is to urge your customers to pay their bills sooner simply. If only it were that easy. 

    Small businesses prefer invoice financing versus factoring because fees and payback procedures are more straightforward with invoice financing. Due to this openness, there will be fewer shocks, and future costs will be more accurately predicted. If you're running a growing business and want greater control over your cash flow, invoicing financing is a great option.

    About the Author

    Ezra Neiel Cabrera has a bachelor’s degree in Business Administration with a major in Entrepreneurial Marketing. Over the last 3 years, she has been writing business-centric articles to help small business owners grow and expand. Ezra mainly writes for SMB Compass, but you can find some of her work in All Business, Small Biz Daily, LaunchHouse, Marketing2Business, and Clutch, among others. When she’s not writing, you’ll find her in bed eating cookies and binge-watching Netflix.