Cash flow is the lifeblood of growing businesses, essential for covering costs in every area of their operations. Yet it's the rare business that isn't occasionally affected by slow or uneven cash flows. In some cases, poor cash flow may mean missing out on an opportunity to grow the business. In other cases, consequences can be as dire as a company going out of business because it can't pay its debts.

Invoice factoring is one way to smooth out cash flow challenges. Typically used by small and medium-sized businesses (SMB) in business-to-business (B2B) industries, the process involves sell of unpaid invoices to a third party, known as a factor or factoring company, which retains a percentage of the original invoice amount. For a small company, factoring often provides faster access to cash than bank financing because factors are less likely to be deterred by a small company's credit history.

What Is Invoice Factoring?

With invoicing factoring, a business sells any number of unpaid invoices to a factor for less than the amount it is owed. In return, the business receives the majority of the invoice amount — as much as 90% — within a few business days, rather than having to wait the 30-, 60- or 90-day period specified on the invoice. In most factoring situations, the factor becomes responsible for collecting on the invoice.

Once the factoring company receives full payment of the invoice, they pay the balance of what is owed to the seller, keeping a percentage of the total invoice amount as revenue.

Invoice factoring vs. invoice financing:

Invoice factoring and invoice financing are two types of accounts receivable financing. Invoice financing is similar to invoice factoring in that it's a way for businesses to get paid quickly on an invoice, rather than having to wait weeks or months before payment is officially due. However, invoice financing doesn't involve selling invoices. Rather, the company uses them as collateral for borrowing money from a lender. Collection remains the company's responsibility. Invoice financing involves somewhat less work than invoice factoring; hence, the associated fee is usually somewhat lower than that incurred through invoice factoring.

Key Takeaways

  • Invoice factoring involves selling unpaid invoices to a third-party company so that a business can improve its cash flow in order to fund operations or pursue growth opportunities.
  • A factoring company pays the business the majority of the invoice up front and the balance when the invoice is paid by the customer, minus its factoring fee.
  • Invoice factoring is most often used by growing businesses that don't have the time or necessary credit to get a bank loan.
  • Downsides include higher costs than those related to conventional bank loans and diminished control over customer interactions.

Invoice Factoring Explained

Most companies need to be profitable to stay in business — i.e., their revenues must exceed their expenses. But profitability doesn't always equate to positive cash flow. If a company has customers with extended payment terms it can make it difficult for them to meet their financial obligations. This situation can become almost as perilous as if the company's entire business is unprofitable.

Invoice factoring is a way to cushion some of the effects of delayed payments and the cash flow problems they may create. The approach is most often used by startups and growing companies that are trying to act quickly and may not want to go through the conventional bank loan application process. Factoring can be more costly than other kinds of financing, but many companies like the assurance it provides that they'll obtain needed cash quickly.

How Does Invoice Factoring Work?

In a typical business situation, a company makes a sale, creates an invoice and sends it to the customer. Thirty, 60 or 90 days after the good or service is delivered, as stipulated on the invoice, the buyer pays for the purchase, and the company gets its money.

But what if the company finds itself in a position where, for any number of reasons, it can't wait? With invoice factoring, the company can sell the invoice to a third party, called a factoring company or factor, which buys unpaid invoices at a discount. The factor negotiates the amount they're willing to pay and agree to payment terms — a certain amount will often be paid up front, with the remainder being paid after the factor collects.

Bear in mind, not every invoice is a good candidate for factoring. Most factors won't buy invoices that are already past due, and many won't buy invoices whose payment terms exceed 90 days.

The process of invoice factoring, using a hypothetical company, looks like this:

process of invoice factoring

When determining whether to purchase an invoice, the factoring company will examine a business's customers and the likelihood they will remit the full value of the invoice. To this end, the factor will look at the customers' credit ratings, try to assess their accounts payable performance and consider other issues that may affect payment, such as outstanding litigation. The factor must also make sure the invoice is valid, which may include a review of shipping statements and other documentation.

Most factoring agreements include a “recourse” provision, meaning the company selling the invoice must return some or all of an advance cash payment if a customer doesn't pay. Conversely, the factor will assume the risk of nonpayment in a non-recourse factoring arrangement. Non-recourse factoring typically carries a higher fee.

Why Is Factoring Important?

Factoring alleviates cash flow concerns during a slow period, especially for companies with few resources and slow-paying customers. Just about every small-business owner knows what it's like to lie awake at night wondering whether they're going to be able to make their payroll or cover some other critical business expense. A lack of cash could also keep a business from paying its own vendors on time or from seizing an opportunity such as working with a major new retailer in time for the holidays or expanding internationally. Cash-strapped companies have little choice but to make short-term decisions that may cut off or limit long-term opportunities.

When Should Companies Use Invoice Factoring?

Invoice factoring generally makes the most sense for growing B2B businesses with good — but often slow-paying — customers. The definition of “slow,” of course, is relative to the business's point of view, but even standard net 30 payment terms can be problematic if the invoice is a big part of the company's near-term revenues. It can make or break a company's ability to take advantage of a new business opportunity, particularly if it does not have enough business history or collateral to secure a line of credit with a bank, or a decision must be made before a loan application process can be completed. That brings us to one of the benefits of using invoice factoring: The company's own credit matters less than that of its customers, who are, after all, the ones who will be paying the factor.

A business might also turn to factoring so its employees in finance don't have to spend time on collections, which can be a frustrating and thankless activity.

Advantages of Invoice Factoring

A business may consider invoice factoring for a variety of reasons. Here are five of the most important:

  • Fast receipt of cash.

    Companies that work with third-party factors typically receive a substantial portion of the value of their invoices within a few business days — sometimes within 24 hours. That timely cash flow can provide smaller companies, in particular, with peace of mind about their ability to cover near-term expenses.

  • Removal of a likely distraction.

    Slow-paying customers — and, of course, those whose bills are overdue — can cause big headaches, especially for small businesses. If it's the owner who has to follow up on a late invoice, that's time not spent with other customers or on higher-value activities. If an accounts receivable department handles collections, the tedious time spent chasing down a delayed payment may impact morale.

  • Quicker approvals than with bank loans.

    Bank loans or lines of credit are certainly a possibility for access to cash. But they can take a long time to get and, for many small businesses, may be capped at levels that limit the company's ability to grow. The approval process for invoice factoring is much faster, and, given how the arrangement works, factors often provide more cash than banks.

  • Less scrutiny of a founder's personal credit history.

    Bank loans typically depend, in part, on the credit score of the company's founder. This can be problematic for many small-business owners, especially if funding the business has required significant credit card use. Fortunately, an invoice factor is more interested in the credit rating of the customer that has placed an order than in the company whose invoices it purchases.

  • Helping businesses work with important new customers and accounts.

    Some very big and otherwise reliable customers have payment schedules that may be too stretched out for small businesses. The problem of payment timing could possibly complicate their ability to fulfill a very large, potentially fortune-changing, order, such as one from a government entity or a Fortune 500 company. Invoice factoring may help them fulfill these new orders.

Disadvantages of Invoice Factoring

Factoring also has some downsides that a business should consider before selling an invoice to a third party. Disadvantages include:

  • Requires a big commitment.

    Factoring companies occasionally provide so-called “spot,” or selective, factoring, meaning that they offer their services for a single invoice. More often, though, factoring companies only work with businesses that are willing to turn over most or all of their invoices. Sometimes a contractual minimum is set and a fee is charged when invoices don't meet that minimum.

  • Can be expensive.

    As with bank loans, a factor's fees are partially dependent on perceived risk — though with factoring, the credit assessment is of a company's customers, not the company itself. Even in cases where the risk of nonpayment is low, a factor's fees are generally several percentage points higher than the percentage a business would pay in interest for a bank loan.

  • Doesn't shift the payment risk.

    Working with a factor means an earlier receipt of cash, but it doesn't necessarily offer a company protection against a nonpaying customer. If an invoice goes unpaid, the selling company must typically return the cash advanced by the factor unless a “non-recourse” clause is in place. However, inclusion of this clause increases the price of the arrangement.

  • Allows less control over certain customer interactions and impressions.

    In most factoring arrangements, the factor takes responsibility for ensuring that the invoice gets paid. This is part of the value of factoring — one less chore for a company selling an invoice to worry about. But it also means the company loses control over the handling of collection requests. An overly aggressive factor, focused on its own short-term needs, could negatively affect a customer's impressions of the company it purchased from. A factor's presence may also lead customers to think that the company doesn't have the proper resources to handle its business.

These downsides can be managed. For instance, a company can opt for confidential factoring, wherein the factor represents itself as part of the company's financing department. Or it can opt to handle its own invoice-collection efforts, even after ownership of the invoice has passed to a factor. This is known as “CHOCC” factoring — short for “client handles own credit control.” But these approaches come with their own inherent risks, as well.

Invoice Factoring Example

Sophie's Churn, a hypothetical maker of premium yogurt in Portland, Oregon, achieved local success selling to gourmet stores and a big co-op in its health-conscious home city. It hand-assembled and sold 2,000 units a month with the help of two employees.

After being featured on a network television show, Sophie's Churn was approached by a national grocery chain that wanted to purchase 20,000 units of the yogurt. This is windfall for Sophie's Churn, adding $80,000 in monthly revenue based on its per-unit wholesale price.

Fulfilling the order was going to cost the company $49,000, and the $56,000 Sophie's Churn had in its bank account seemed ample. But with only $7,000 remaining on the day Sophie's Churn fulfilled the order, and 45 days until payment was due, the owner was feeling uneasy. So she approached a factoring company with experience in the food service and retail industries. The factoring company checked to make sure that the grocer — which owed the money — didn't pose a payment risk, and two days later it agreed to buy the invoice. It charged a 5% fee, or $4,000, on the total invoice value ($80,000). The next day, the factor wired $64,000 to the business account of Sophie's Churn — the pre-agreed 80% of the order's value to be paid up front. When the grocer paid the invoice six weeks later, the factoring company paid Sophie's Churn another $12,000 — the unpaid portion of the invoice minus its $4,000 fee.

Cost of Invoice Factoring

The price discount the factor expects is affected by the volume and dollar amount of the invoices — the higher for each, the lower the rate may be — plus any risk that the customer might not pay and the number of days remaining until payment is due. In addition, the discount rate may be influenced by how many alternative sources of financing a company has at its disposal.

Another consideration, which could drive up the factoring cost, is whether the company opts for a non-recourse agreement, where the factoring company assumes the risk of customer nonpayment. Some factoring contracts also specify a minimum-volume. For instance, a contract may call for $150,000 worth of invoices per quarter. If the invoices fall below that level, the factor charges a fee. Other costs may include application fees and fees for assessing the risk of individual orders.


Cash flow constraints are an undeniable business impediment. Invoicing factoring is one way to address the problem. By selling unpaid invoices to a third-party factoring company, a business receives the majority of their value within a few business days. It then has the cash on hand to fulfill new orders, pay its own expenses and pursue growth opportunities. The business receives the remainder of the invoice's value when the factoring company collects payment from the customer. For many small businesses that can't or don't want to work with banks, factoring is an attractive financing option.

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Invoice Factoring FAQs

It depends on who is seeking the funding. Invoice factoring isn't widely used by large companies with access to bank loans or lines of credit. Small and medium-sized businesses may find invoice factoring appealing as a means of helping them improve their cash flow and ensuring they can pay their expenses.

How much does factoring invoices cost?

The main cost of invoice factoring is the so-called discount rate on the invoice. This is typically between 2% and 5% of the invoice's total value, though the rate can be outside this range depending on the volume of business and the risk the factoring company is taking.

What is the difference between invoice factoring and financing?

Both are mechanisms that growing businesses may use to generate cash. In invoicing factoring, the invoice is sold to a factoring company, which also assumes responsibility for collection. In invoice financing, the invoice serves as collateral for either a term or a revolving loan from a financial company.