Complete Guide to Invoice Factoring

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Waiting for customers to pay their outstanding invoices: it’s a common problem for small businesses.

Most invoices are set to payment terms of 30 to 90 days, meaning that from the day an invoice is sent to your customer, you’re unlikely to see that money for at least a month, if not longer. These long payment cycles put small business owners like you in a constant cash crunch, making it hard to keep up with critical expenses like payroll, utilities or inventory. That likely prevents you from investing in growth opportunities or maintaining day-to-day operations that keep everything on track.

That’s where invoice factoring comes in. It’s a form of cash flow financing that helps your business turn your outstanding invoices into cash immediately. By getting paid faster, you’re able to put that cash you’ve earned to work, paying your expenses and employees on time and growing your business without the heavy burden of delayed customer payment.

This guide will help you understand what invoice factoring is and how it works, and determine if it’s a good fit for your small business. If you have questions as you read, feel free to reach out with any questions by submitting the contact form at the bottom of this page.

Northstar Logistics factoring

What is invoice factoring?

Invoice factoring is a form of financing that involves selling your accounts receivable to a third party (factoring company) in exchange for cash up front. Because it’s a sale, not a loan, it doesn’t impact your credit like traditional bank financing. To prevent any confusion, the term “factoring” is often used interchangeably with “accounts receivable financing”. It allows small businesses to unlock the cash value of their invoices long before their customers pay their bills.

Is factoring the same as accounts receivable financing?

The main difference between invoice factoring and accounts receivable financing lies in the underwriting criteria of the deal structures. While factoring offers greater flexibility, A/R financing has more strictness around the credit profile. Consequently, A/R financing typically offers preferred financing terms.

Both invoice factoring and accounts receivable financing benefit businesses by providing funds in advance of collection. When working capital is critical to your business operations – as it is for nearly everyone – both of these financing options quickly put money into the business. In addition, both offer professional credit services and receivables management. Many providers will offer both factoring and A/R financing.

Read more about the differences in invoice factoring and accounts receivable financing.

Invoice factoring vs. invoice financing

The main difference between invoice factoring vs. invoice financing is who eventually collects on your invoices. With invoice financing, you retain control of collection. In invoice factoring, however, the factoring company assumes the roll of collecting on the invoices they purchased. Other than the collection process (i.e. assignment), both forms of financing are nearly identical.

Invoice factoring vs. invoice discounting

A common misconception is that invoice factoring and invoice discounting are the same thing. While, they are similar, there are some key differences. Mainly, factoring is a transparent process and invoice discounting is more confidential. Read our full article on invoice discounting for more information.

What is a factoring company?

A factoring company (or “factor”) is a financing partner that purchases your invoices in exchange for cash.

Once you are approved to work with the factor, you can sell your outstanding receivables in order to boost working capital and avoid the delay of long payment terms. The factoring company verifies your invoices, funds up to 90% of the invoices, then collects on those invoices directly from your end customers. Once the factor collects from the end customer on the standard payment terms, they release the remainder of the invoice value to you, minus a small factoring fee – typically one to five percent.

How does invoice factoring work?

Who’s involved in a factoring transaction?

  • The Seller (Your business)
  • The Debtor (Your business’s customer)
  • The Factor (The factoring company)

The five steps of invoice factoring:

  1. The Seller provides a service or delivers a product, then sends an invoice to the Debtor.
  2. The Seller submits that invoice to the Factoring Company for funding (for example, on Day 1)
  3. The Factoring Company advances between 80-90% of the invoice value to the Seller, deposited into their business bank account (for example, on Day 2)
  4. The Debtor mails their payment to the Factoring Company, which goes into a lockbox in the Seller’s name (for example, on Day 25)
  5. The remaining 10-20% of the invoice value is released to the Seller, minus a small Factoring fee (for example, on Day 26)

Factoring advantages and disadvantages

While there are many positives to invoice factoring, there are also downsides, depending on the nature of your small business and the factoring partner you choose to work with. Here, we’ll break down the the pros and cons so you can see the full picture.

Pros of factoring

  • Immediate access to cash for your business
  • Easier and faster approval than traditional bank lending
  • No impact on your credit score

Cons of factoring

  • The stigma that comes with it
  • Reduced profit margins for your business
  • Hidden costs and fees from bad factoring companies

Read more about all of the advantages and disadvantages of factoring and the invoice factoring approval process.

Are Factored Receivables Subject to Taxes?

So, invoice factoring presents many potential advantages for a company. But how does factoring fit into the tax system in the United States? This relationship is somewhat complex. For business owners, it can be difficult to identify whether factored receivables are subject to taxes payable to the federal government.

The IRS considers several factors in determining whether any factored receivables qualify as taxable. The purpose of this determination is to prevent firms from using invoice factoring to transfer income overseas or engage in tax avoidance or tax evasion regarding the use of invoicing.

For more information, read our full article about taxes and factoring.

Common myths about invoice factoring

You may have heard some bad things about invoice factoring, potentially from someone who has used it before and had a bad experience. While there are certainly better factoring companies than others, and some that will try to take advantage of you, here are a few things about invoice factoring that aren’t true.

  1. It’s only good for struggling businesses: Not true! Factoring can be a great cash flow solution for businesses of all sizes and stages of growth. For example, many large companies employ factoring simply to reduce debt.
  2. It’s too expensive to be sustainable: While factoring is typically more expensive than traditional loans, most businesses that are a good fit for factoring have pricing power, meaning that they can incrementally increase their prices to compensate for factoring costs.
  3. You can’t use factoring if you have bad credit: Wrong! Invoice factoring is often the best fit for businesses with bad credit. That’s because factoring companies really only care about the creditworthiness of your customers (because they’re the ones paying the invoices), not you as a business.
  4. All factors are the same: Every factoring company is different. Some will try to take advantage of you with hidden fees, float, and other added costs that make factoring unsustainably expensive and unpredictable. Factors like Northstar Logistics don’t do that – as a regulated bank, we’re 100% transparent because we have to be, and we want to be.

Read more myths and misconceptions about invoice factoring.

How to choose the right factoring company?

When you start browsing factoring companies (or if you’re looking to switch factoring companies), you’ll find there are tons of options. Many are independent factors, while others are bank-owned. Make sure you do your homework to find the best invoice factoring company. As you search, consider the following things:

Services they offer

Recourse vs. Non-Recourse Factoring

Recourse: If your customer fails to pay their invoice to the factor, you must pay back the recourse factoring company for the amount advanced. While this adds risk for you, recourse factors offer lower fees. For reference, Northstar Logistics is a recourse factor.

Non-Recourse: In non-recourse factoring, if your customer fails to pay their invoice to the factor, the factor assumes responsibility for the loss, not your business. This is lower risk for you, but generally comes with higher factoring fees.

Spot Factoring vs. Whole Ledger

Spot Factoring: Spot factoring allows you to factor only one invoice. Let’s say you have one large outstanding invoice that you need paid now, a spot factor will fund that one invoice alone.

Whole Ledger Factoring: Whole Ledger factoring means that the factoring company requires that you factoring all of your invoices together. Some businesses don’t have payment delay issues across all customers, so this may not be preferable.

Industries they serve

Generally, factoring works best for small B2B businesses and startups within the following industries:

  • Staffing
  • Manufacturing
  • Consulting
  • Food and Beverage
  • Oil and Gas
  • Transportation and Trucking
  • Professional Services
  • Apparel Companies
  • Janitorial Services
  • Wholesale and Distribution

Rates, fees and structures

When it comes to factoring rates and fees, the main drivers are:

  • The size of the your borrowing need
  • The creditworthiness of your customers
  • Invoice amount and the age of your receivables
  • Whether all or only select invoices will be financed

Keep these in mind when you’re considering your factoring options. For more information about how each of these items impacts your total factoring cost, read our full article on understanding invoice factoring rates.

Hidden fees and float in the factoring agreement

Many independent factoring companies will try to charge you hidden fees buried deep inside your factoring agreement. Make sure you read your contract thoroughly and ask questions about anything that looks suspicious – it will save you time and money in the long run. The best invoice factoring companies will be 100% transparent with their customers, like Northstar Logistics. As a bank, we’re fully regulated and are both unable and unwilling to deceive our factoring customers. That said – we’re not the norm. Watch out for these kinds of hidden fees:

  • Monthly minimum fees
  • Maintenance fees
  • Cancellation or Termination fees
  • Float days and fees
  • Due diligence fees

For more information about these specific fees and what they mean, read our full articles on understand invoice factoring agreements and invoice factoring float and other hidden fees explained.

Should you factor with a bank?

Independent vs. bank factoring

While the overall goal of invoice factoring is the same, choosing the right provider is critical. Let’s summarize the differences.

Independent factoring company:

Independent factoring companies work with businesses who need to accelerate cash flow and may have been turned down by a bank. A business with creditworthy customers may be eligible to factor even if it can’t qualify for a loan. However, an independent factor must borrow from a third party in order to fund your invoices. That can increase risk and costs for your business, and can reduce efficiency.

Bank factoring company:

A bank factor provides the same flexibility and benefits as an independent factor, but also offers additional advantages.

Easier transition to bank loan – A bank factor works with many businesses who are considered outside of the traditional credit box. Many of these businesses have been told “no” by a bank for a commercial loan, but they are still very strong candidates for working with a bank that offers factoring, or accounts receivable financing. Businesses that work with a bank owned factoring company may also have an easier time transitioning to a commercial loan at a later date.

Greater security – Banks are more secure and provide a sense of financial stability for the business. A business’s clients are very valuable relationships and a bank offers a level of comfort not found in independent alternative financing companies like BlueVine or Fundbox. Clients feel better about interacting with a bank than an unfamiliar or unknown business entity.

Competitive rates – In addition, since the bank has its own funds, it can offer the business very competitive rates. Unlike many independent factoring companies who work with multiple funding sources, a bank acts as a direct source of funds and eliminates the middleman.

Is invoice factoring a fit for your business to improve cash flow?

Cash flow is the lifeblood of a business, and it can determine if the business grows or dies. If you’re considering invoice factoring, it probably means you’re looking for quick and reliable source of funding. Factoring can do just that: quickly turning your receivables into cash.

But what makes your business a good fit for invoice factoring? If you meet any or all of the characteristics below, it may be the right solution for your business.

  • Do you have B2B customers?
  • Does your business collect COD payments?
  • Do you offer payment terms between 30 and 90 days?
  • Do you have fair or poor credit?
  • Does your business have limited operating history?
  • Do you have few or no assets to borrow against?

These are each legitimate reasons to consider invoice factoring.

Factoring vs. other types of small business lending

While there are many types of small business loans and alternative financing out there, not all are a fit for every business. Some require a certain credit score, or a minimum operating history. Others can be fast and easy, but expensive and predatory. What you’re looking for is a type of small business lending that fits your needs at a reasonable and manageable cost.

Here are some of the other types of lending you may encounter, aside from invoice factoring:

  1. Traditional Line of Credit
  2. Purchase Order Financing
  3. SBA (Small Business Administration) Loans
  4. Asset Based Loans
  5. Equipment Financing
  6. Inventory Financing
  7. ACH Loans
  8. Merchant Cash Advance

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