For many small businesses in Canada, cash flow management is a critical challenge. If you find yourself waiting for customers to pay their invoices while needing cash to cover expenses, invoice factoring could be a practical solution.

In this guide, we’ll explore what invoice factoring is, how it works, and whether it’s the right choice for your business.

• What is invoice factoring?
• How does invoice factoring work?
• Example of invoice factoring
• Why do small businesses factor invoices?
• Pros of invoice factoring
• Cons of invoice factoring
• Industries that commonly use invoice factoring
• How to qualify for invoice factoring
• Factoring fees: What to expect
• Alternatives to invoice factoring
• Managing invoice factoring in QuickBooks
• FAQs

What is invoice factoring?

Invoice factoring is a financial solution that allows businesses to convert unpaid customer invoices into immediate cash. Instead of waiting for customers to pay, a business sells its invoices to a factoring company at a discount. The factoring company advances a percentage of the invoice's value upfront and pays the remainder (minus fees) once the customer settles the invoice.

How does invoice factoring work?

By partnering with an invoice factoring company, you can advance a portion of your accounts receivable and improve your cash flow without waiting for clients to settle their accounts. Here’s a step-by-step look at how the process works:

1. Choose a factoring company: Select a reputable factoring company that fits your business needs.
2. Submit invoices: Send your outstanding invoices to the factoring company.
3. Receive an advance: The factoring company will send you a percentage (usually 80% to 90%) of the invoices' value.
4. Wait for customer payment: Your customer will pay the factoring company directly.
5. Settle up: The factoring company will pay you the remaining balance, minus their fees.

Example of invoice factoring

Say your small business needs $35,000 to replace some necessary equipment quickly, but you don’t have the working capital to do so. Rather than reaching out to a traditional bank for a loan, you decide to take a look at your accounts receivable.

You notice you have $40,000 in outstanding invoices and decide to sell your accounts receivable to an invoice factoring company. The company agrees to buy your accounts receivable for the value of the invoices minus a factoring fee of 4%.

Thus, the invoice factoring service will pay you a total of $38,400 ($40,000 x 96%) for the invoices. Typically, you will get a cash advance for a portion of the total amount within a few business days. 

After the factoring company collects all payments for the invoices, they’ll send you the remaining balance.

Using our example, here’s what the invoice factoring process looks like: 

• Invoice values: $40,000
• Fee (4% as an example): $1,600
• Initial cash advance (85% of the invoice minus the fee): $32,400
• Remaining advance: $6,000 
• Total you’ll receive: $38,400

Why do small businesses factor invoices?

Factoring invoices can be a convenient solution to access immediate funds without having to wait for payment from clients. Small businesses often choose to do invoice factoring for a variety of reasons, such as: 

• They need immediate cash flow: Invoice factoring provides small businesses with quick access to funds to address cash flow problems and meet immediate financial obligations.
• They can avoid debt: Unlike traditional bank loans, small business invoice factoring does not require taking on additional debt. This can be useful for small businesses that may not qualify for loans or want to avoid increasing their debt load.
• They want flexible financing: You can factor invoices as needed, allowing small businesses to selectively factor in certain invoices rather than committing to a long-term loan. This flexibility can be valuable for managing fluctuating cash flow.
• They can grow their business: The immediate cash from factoring can help small businesses fund growth initiatives, such as purchasing new equipment or inventory, without waiting for customer payments.

Pros of invoice factoring

Invoice factoring provides several benefits for businesses. It can:

• Offer quick access to cash, faster than traditional loans.
• Be easier to obtain than business loans, which is especially beneficial for small businesses.
• Enable you to use invoices as collateral, preserving your business assets.
• Help you maintain a smooth cash flow by converting receivables into immediate funds.
• Allow for extended payment terms to customers without straining cash flow, supporting business growth.

Cons of invoice factoring

Despite its benefits, invoice factoring also has some drawbacks that businesses should consider before deciding if it is the right financial solution:

• It can be more expensive than traditional financing, with fees that may result in effective annual rates ranging from 20% to 50%.
• It is best suited for short-term cash flow needs; frequent use can significantly erode profits.
• It may impact client relationships, as some customers prefer direct communication with your business rather than a third-party factoring company.
• The process can be labour-intensive, depending on the factoring company’s requirements, potentially increasing your administrative workload.

Industries that commonly use invoice factoring

Invoice factoring is particularly popular in industries where businesses operate on credit terms. Here are some examples:

• Construction: Contractors often use factoring to cover expenses while waiting for project payments.
• Manufacturing: Manufacturers use factoring to manage cash flow between production and payment.
• Logistics: Logistics companies factor invoices to manage operational costs like fuel and wages.
• Professional services: Law firms, accounting firms, and recruitment agencies use factoring to manage extended payment terms.

How to qualify for invoice factoring

Qualifying for invoice factoring is generally easier than securing a business loan. Here’s what factoring companies typically look for:

• Business and client history: Invoice factoring companies will review your business’s age, industry, and client payment history.
• Invoice terms: Factoring companies prefer to work with companies whose invoices include clear payment terms and reliable payment timelines.
• Creditworthiness: While your business credit score is considered, the creditworthiness of your clients is more critical because the factoring company’s decision to advance funds is largely based on the likelihood that your clients will pay their invoices on time, ensuring the factoring company recoups its investment.
• Bank statements: Some companies may request bank statements or set up a direct connection to your business bank account.

Factoring fees: What to expect

Factoring fees can vary depending on the company and the specific terms of the agreement. Some companies charge a flat fee, which is a single amount deducted upfront from the invoice value. Others may use a variable fee structure, where a percentage is charged at regular intervals, such as 1% every 10 days.

In some cases, a combination of both flat and variable fees is applied, with the fee structure depending on the duration of the invoice. If you choose to work with an invoice factoring company, be sure you're clear on their fee structure.

Alternatives to invoice factoring

If invoice factoring doesn’t seem like the right fit for your business, there are several alternatives to consider. Invoice financing offers a similar solution but allows you to retain control over your invoices and maintain direct client relationships.

Traditional business loans can provide longer-term funding options, offering stability and potentially lower costs.

Additionally, a business line of credit provides flexible access to funds as needed, without the need to sell your invoices, making it a versatile option for managing cash flow.

Managing invoice factoring in QuickBooks

QuickBooks Online makes it easy to record factoring transactions. Here are the steps you would take to record invoice factoring:

1. Record advance payments: Use the “Receive Payments” feature to record the initial advance.
2. Apply discounts: Use the “Discounts and Credits” function to apply factoring fees.
3. Track remaining balances: Monitor the outstanding balance and final payments to keep your records accurate.

Invoice factoring can be a valuable tool for maintaining cash flow in your small business, but it’s essential to weigh the costs and benefits carefully. Whether you choose factoring or another financial solution, QuickBooks provides the tools you need to manage your finances efficiently.

Learn more about how QuickBooks Online can help support your business.