All companies need stable cash flow to keep operations running smoothly, but new, small, and growing businesses often find this especially difficult to maintain.
As a result, many turn to invoice factoring. This alternative financing option has become a popular way to improve cash flow, maintain steady working capital, and simplify accounting tasks.
This guide offers a clear overview of invoice factoring, including how it works, its benefits, costs, and more. By the end, you’ll have a better idea of whether it’s the right financing solution for your business.
What Is Invoice Factoring?
Invoice factoring, often called “payroll funding” or simply “factoring,” is a type of receivables-based financing. It involves selling outstanding invoices to a third-party company in exchange for an immediate cash advance. These third parties are known as factoring companies.
The advance is usually between 80-95% of the invoice value, depending on the industry, the age of the invoice, and the business’s financial background.
How Factoring Works
Factoring is a straightforward process once an agreement has been signed. Here’s how it typically works:
- A business invoices its customer (also called “debtor”) and sends a copy to the factoring company.
- The factoring provider advances 80-95% of the invoice value to the business, usually within 24 to 36 hours. The factor then takes over collection responsibilities.
- When the customer pays the invoice, they send payment directly to the factoring company.
- Once payment is received, the factoring company releases the remaining 10 to 20% to the business, minus a small factoring fee.
This process repeats for each new invoice.
Benefits of Factoring
Factoring offers a range of both financial and operational benefits. Below are some of the most common advantages.
Improved Cash Flow
The main reason business owners choose factoring is to improve cash flow. Working with extended payment terms such as net 30 or longer can create financial stress, especially for businesses operating on tight margins. Each day without payment can make it harder to cover expenses.
By using invoice factoring, vendor payment schedules no longer dictate your cash flow. Instead, you receive most of your funds within one or two business days.
Increased Working Capital to Support Growth
When you’re trying to scale, uncertain payment timelines make it risky to take on new business. Factoring ensures you have enough cash on hand to cover payroll, suppliers, and new contracts. With steady working capital, you can plan more confidently and invest in growth opportunities.
Reduced Accounting Work
Factoring companies also take over collections, which can save you hours of administrative work each week. That time can then be spent on higher-value activities like sales, customer service, and business development.
Better Credit Risk Management
Before approving invoices, factoring companies typically review your customers’ credit through a complimentary credit check. This helps identify clients with poor payment histories and reduces the risk of unpaid invoices. Working with reliable customers helps prevent financial setbacks.
Access to Financial Expertise
Many business owners view their factoring partner as an extension of their financial team. Along with funding, factoring companies can offer guidance and support to help improve cash flow management.
The benefits of factoring are multi-layered. There are several well-known advantages, along with others that many first-time users might not have considered.
Uses for Your Factoring Cash Advance
While there are few limitations to how you can use factoring funds, some of the most common uses include:
- Funding payroll
- Restocking inventory
- Covering emergency one-time expenses (equipment repairs, urgent orders, etc.)
- Covering routine operating expenses
- Managing overhead costs
- Paying suppliers
- Fulfilling large orders that would otherwise be delayed by slow-paying clients
A factoring advance frees up cash for daily operations and growth, and it means you don’t have to scramble if an emergency expense comes up.
Invoice Factoring Rates and Fees
Factoring rates generally range from 0.75% to 5.00%. However, the exact rate will vary based on a few aspects:
- Invoice volume: The more invoices you factor, the lower your effective rate.
- Invoice age: The longer an invoice remains unpaid, the higher the cost.
- Customer credit quality: Better debtor credit typically means lower fees.
- Debtor concentration: The higher the debtor concentration (meaning you have fewer customers), the higher the factoring fee.
Many factoring companies use a tiered fee structure. For example, invoices paid within 30 days might carry a 1.5% fee, while those paid after 40 days could increase to 2.0%. The faster your customers pay, the less you’ll spend in fees.
This highlights the importance of working with customers who pay on time. The more reliable their payment habits, the lower your factoring rates will be.
Industries Where Factoring Is Most Common
Invoice factoring is common across many industries, but several have developed a reputation for being especially factoring-friendly, including:
- Staffing
- Transportation & trucking
- Manufacturing
- Wholesale & distribution
- Consulting
- Oil & gas
- Business services
- Government contractors
- Food & beverage
- Apparel companies
- Construction
Types of Factoring Companies
While the general goal of factoring is uniform (to improve cash flow), choosing the right provider makes a big difference in how effective this form of financing can prove for businesses.
There are two main types of factoring companies: independent providers and those backed by a bank.
Independent Factoring Companies
Independent factoring companies can provide fast access to funds for your outstanding invoices. However, most of them rely on outside lenders to supply the capital they use, which can increase costs, slow down funding, and add some risk to the process.
Another drawback is that independent factors aren’t FDIC-insured and don’t face the same level of regulation as bank-affiliated providers. That lack of oversight can sometimes open the door to less favorable terms or predatory practices.
Much of the negative reputation surrounding factoring actually comes from these unregulated, independent players who have taken advantage of small businesses in the past.
Bank Factoring Companies
Bank-owned factoring companies offer the same core benefits as independent factors but come with a few added advantages that can make a big difference over time.
Easier Path to Traditional Financing
Many businesses that use factoring have been turned down for a commercial loan. Working with a bank that offers factoring or accounts receivable financing can serve as a stepping stone. Once your business has built a track record, it’s often easier to transition into a standard business loan later on.
Greater Financial Security
Banks are federally regulated and FDIC-insured, giving business owners peace of mind and a sense of stability. It’s usually more comfortable working with a well-known financial institution than with a smaller, unfamiliar company.
Competitive Rates
Because banks use their own funds, they can typically offer lower and more predictable rates. Independent factoring companies often rely on several outside funding sources, which means higher costs and more middlemen. A bank-backed factor cuts out that extra layer and passes the savings on to you.
In short, both types of providers can help improve cash flow, but bank-backed factoring companies tend to offer more stability, stronger safeguards, and better long-term value.
Is Invoice Factoring a Fit for Your Business?
Invoice factoring can be a great tool for many types of businesses, but it is not a fit for everyone. In addition to having a B2B business, your company is likely a fit if any of the following apply:
- Your customers take 30, 45, 60, or even 90 days to pay their invoices
- You work with reliable and creditworthy debtors
- You don’t qualify for a bank loan or line of credit
- Your cash flow is consistently strained
- Your business is in a high-growth mode
- You provide completed goods or services upfront
- You work in an industry with long payment cycles
Why Use PayrollFunding.com?
If you’re interested in learning more about factoring (also called “payroll funding” in the staffing industry) or think your business might be a fit, fill out our quote form to get matched with an invoice factoring company. Our team of representatives will be happy to help you achieve your growth goals.
Invoice Factoring FAQs
Still have questions about invoice factoring? Review our frequently asked questions below for further information.
Why should I use invoice factoring?
Invoice factoring can be an excellent fit for B2B companies that struggle to access traditional types of financing and do not want to use predatory lending options, such as merchant cash advances. Factoring is easier to qualify for than bank loans, SBA loans, and lines of credit, making it a more accessible type of financing for startups and those with less-than-ideal credit.
If you are looking to borrow a lump sum, factoring is not the best fit; however, if you struggle with cash flow due to long payment terms and need financing that grows with your business, invoice factoring is worth looking into.
How do I qualify for invoice factoring?
While the approval process varies from factoring company to factoring company, getting set up with a provider generally includes the following steps:
- Customer completes a factoring application
- The factoring company does an initial credit check to make sure the customer meets a designated threshold (they usually look for a FICO of 500 or higher)
- If the credit check comes back clear, then the customer will provide several documents to begin the underwriting process, which generally includes the following:
- Accounts receivable aging report
- Articles of incorporation
- Financial statements
- Copies of recent tax returns
- List of customers
- Sample invoices
- Once underwriting is complete, the factoring company will send the contract to the customer for signing
Throughout the approval process, the factoring company will look for disqualifiers such as multiple bankruptcies, too low of a credit score, and indications of fraud.
What is the difference between invoice factoring and invoice discounting?
The factoring industry is largely unregulated, which results in there being inconsistent definitions of accounts receivable financing terms. Some use the phrases “invoice factoring” and “invoice discounting” interchangeably. Others consider invoice discounting to be the same as factoring except for the fact that the customer retains the responsibility of collecting invoice payments. If you are unsure which structure you’re being offered, or how the provider defines these terms, don’t hesitate to ask your sales representative for clarification.