When your business is short on cash, you may want to explore invoice factoring. Factoring allows you to turn unpaid invoices or accounts receivable into cash.

Here’s how it works: a factoring company gives you a certain percentage of the face value of your unpaid invoices. Then, your clients pay the factoring company instead of your business. As the factoring company receives those payments, it gives you the remaining balance, minus a fee, which is usually a few percentage points of the invoice’s face value. The details on factoring are a bit more complicated, but that’s essentially how the process works.

When Businesses Turn to Factoring

Businesses turn to factoring when they need extra working capital, and they have a lot of funds wrapped up in accounts receivable. To give you an example, imagine that you run a wholesale food supply and distribution company. Your clients are primarily restaurants who pay you on net 60 terms. That means you invoice them for their orders, and they pay you within 60 days. But, one month, the refrigeration system in your warehouse goes out. To fix it, you need money fast, and rather than taking out a loan, you decide to work with a factoring company to turn your accounts receivable into cash.

This scenario describes just one situation in which businesses may decide to turn to factoring, but the gist is that companies can use small-business invoice factoring when they need cash quickly.

Pros and Cons of Invoice Factoring

Invoice factoring can be a very convenient and relatively easy way to secure extra money when you need it but, like any other financial product, factoring has its fair share of pros and cons.

Often, businesses turn to factoring because of the following advantages:

• Provides quick access to cash: Some factors will advance cash to you within 24 hours of when you submit your application, and even when the funding is not that fast, it’s usually quicker than applying for a business loan. Additionally, when you use the same company multiple times, you may be able to get the cash even faster.
• Doesn’t require you to apply for a loan: Although you have to submit an application to work with a factoring company, the process is usually much easier and less involved than applying for a traditional business loan.
• Doesn’t require you to give up equity: If you accept funds from investors or venture capitalists, you may have to provide some equity in your company in exchange for the money. That isn’t necessary with business invoice factoring. You retain control over your company and its equity.
• Presents no risk to your capital assets: On the balance sheets, accounts receivable are assets, but typically, they are not as critical to operations as capital assets such as equipment, buildings and land. When you use factoring, you don’t have to use any of these assets as collateral.
• Lets you offer generous payment terms to your clients: Sometimes, you have to offer your clients extra time to pay, because it’s the industry standard. In other cases, you may want to offer your clients extra time in order to get an edge over the competition. If you can’t afford to do that, factoring boosts your working capital so that you can give your clients more time.
• Keeps cash flowing: If clients aren’t paying their invoices in a timely fashion, you may not have the cash you need to cover your business expenses, but you can use invoice factoring to keep the cash flowing.
• Helps with customer credit management: Most invoice-factoring companies assess the creditworthiness of your clients before extending you any payments on your invoices, and in some cases, factors will also give you information on your clients’ credit scores or histories. This can help you determine which businesses should get extra time to pay and which should be required to pay up front or on delivery.
• Relatively easy to obtain: Unfortunately, many businesses struggle to obtain traditional business financing, but because it’s backed by your invoices, factoring tends to be much easier to obtain.
• Accessible to small business owners: Statistically, small businesses are much less likely to receive loans then their larger counterparts, but even small businesses can obtain factoring loans.
• Offers the potential to get more credit: As your business uses one factoring service, it becomes more likely to extend your available credit line, but this varies depending on the value of your invoices and your clients’ payment history.

Some potential disadvantages to invoice factoring include:

• Often more expensive than other forms of credit: Typically, the fee for invoice factoring is anywhere from 1% to 4% of the invoice’s face value for every week or month from the time the factor pays the advance until the client pays the invoice. Although this rate may not sound like a lot, it can add up. Some factoring arrangements end up with an effective annual percentage rate (APR) of 20% to 50%, but the amount can vary drastically.
• Works best as a short-term solution: If you like, you can factor nearly every invoice you receive, but ultimately doing this will cut into your profits. When you need a long-term solution to cash-flow issues, factoring may not be the best option. In these situations, you may need a traditional business loan.
• May be labour intensive: Most invoice-factoring companies require you to upload copies of your invoices and potentially supporting documents, too. This process can be more labour intensive and time consuming than using a line of credit or a business credit card. That said, some factoring companies have very user-friendly dashboards which help to simplify and streamline this process.
• Doesn’t eliminate bad debts: Even if you hand your invoices over to a factoring company, there is still no guarantee that your clients will pay. You will still have to deal with unpaid invoices.
• Forces you to give up some control over client communications: Some factoring companies contact your clients on your behalf. If you work with a factor that uses that approach, you automatically give up some control over your communications with that customer. To be on the safe side, you may want to review any letters or call scripts that are going to be used to communicate with your clients.

Industries That Use Invoice Factoring

Although a wide range of different businesses may want to turn to factoring, the practice is reserved for businesses that issue invoices to their clients, and as a general rule of thumb, factoring companies tend to prefer clients who focus on business-to-business sales. For instance, a company that cleans office buildings for other businesses is more likely to use factoring than a company that cleans homes for individual clients.

The practice is also relatively common in the construction industry. Construction companies tend to invoice their clients, but they also have to deal with buying materials and paying staff while they work on their projects. Whether an independent contractor or a large construction firm, these professionals may turn to factoring when they need a cash infusion.

To give you another example, logistic companies manage the supply chains of other businesses. They may handle packaging, storage and shipping for a manufacturer, but if they need extra money for any part of that process, they also may have to turn to a factoring company for help.

Other industries that may use factoring include:

• manufacturing companies
• printing or publishing businesses
• recruitment firms
• law and accounting firms

How Can Small Businesses Qualify

Just as lenders use a variety of criteria when reviewing loan applications, so, too, do factoring companies. In other words, factoring companies may take different elements into account when deciding whether or not to work with a certain client. But, there are some core similarities from company to company.

Typically, when you apply for factoring, you should be prepared to answer questions about your business and how long you have been in business. Usually, you also need to provide information about your clients, and the factoring company may want to see how your clients have been paying their invoices in the past.

You also need to let the factoring company know what kind of terms you offer to your clients, and of course, you need to provide detailed information on the terms offered in the invoices you want to factor.

On top of this, the factoring company will check your business credit score, and if your business is unincorporated or if you don’t have a business credit score, the company will want to see your personal credit score. Luckily, because these arrangements are backed by your invoices, you usually don’t need as high of a credit score as you would for a business loan.

The factoring company may want to set up a connection with your bank. When you apply for factoring online, you simply enter your online bank login details, then the factoring company generates a single-use token to look at your account information. If you’re not comfortable with that, you can usually provide just a few months’ worth of bank statements.

Invoice Factoring Step-by-Step Instructions

If you’re interested in factoring but aren’t sure where to start, here’s a step-by-step overview of the process:

1. Review multiple factoring companies and choose the best option for your needs.
2. Fill out the online invoice factoring application.
3. Wait while the factoring company reviews your information and decides whether or not to make an offer.
4. Review the terms of the offer and decide if you want to move forward.
5. Sign the paperwork agreeing to the terms and conditions.
6. Submit the invoices you want factored to the factoring company either electronically or by fax.
7. Allow the factoring company to randomly verify some invoices.
8. Notify your clients that you are working with a factoring company.
9. Give your clients any updated information on how to pay their invoices.
10. Accept the advance from the factoring company, which is typically 80% to 90% of the invoices’ face value.
11. Wait until your clients pay their invoices. Depending on your terms, this may take 30 to 90 days.
12. Receive the remainder of the invoices’ face value minus the fee from the factoring company.

Although these are the basic steps, there are a few details that may vary from company to company; in particular, there can be a variety of fee structures.

Factoring Fees Explained

Some factoring companies charge a flat fee. For instance, if the company charges a 4% fee and you have them factor a $100 invoice, you end up paying just $4. But most factoring companies charge a percentage of the balance at regular intervals.

For instance, they might charge you 1% every 10 days, 2% every 15 days, or 3% every 30 days. To see how that works, imagine that you factor an invoice for $1,000 with a factoring company that charges 1% of the balance every 10 days. Let’s say your client pays the invoice after 30 days. Every ten days, you owe $10. That is 1% of $1,000. Over a 30-day period, your fee triples to $30. As a result, you receive $970 total for your $1,000 invoice.

Some companies use a combination of different intervals and percentage rates. For instance, they may charge you 1% for the first 10 days, 2% for the next 20 days, and 4% for the following month. Other factoring companies combine flat fees and a percentage of the balance at regular intervals.

The flat fee is also referred to as the discount rate. That’s because that rate discounts, or reduces, the total amount you’re going to receive. For instance, if a factoring company changes an upfront flat fee of 4%, you will only ever get up to 96% of the invoice; it has been discounted by 4%. The fee that is assessed at regular intervals is called an outstanding utilized balance fee. This is because it’s a fee assessed on the outstanding balance of your invoices, and you are currently utilizing those funds. Make sure you understand how the fees work before you agree to the arrangement.

Recording Factoring Fees in QuickBooks Online

The way you record factoring fees in QuickBooks varies based on your personal preferences and the type of fee arrangement used by the factoring company. If the factoring company charges a flat percentage of the balance, you can record the transaction in the Customer Payment section of the accounting software.

In the Customer Payment menu, select Receive Payments. Then, choose your customer’s name from the Received From dropdown list. If the customer has multiple invoices, place a check mark next to the invoices that have been factored. Depending on how you have set up your software, the payment amount field may automatically populate, but generally, it’s going to populate with the face value of the invoice.

Because you received less than that amount from the factoring company, you will select Discounts and Credits at the top of the screen. A box will pop up, and you will write the discount rate in the Amount of Discount field. You also need to choose the right Discount Account from the dropdown menu. Then, save and repeat this process for every customer whose invoices you have factored. If there is an additional processing fee, you can record that in the relevant expense account.

Accounting for Factoring Rebates in QuickBooks

In many cases, you don’t receive the full amount of the factored invoice upfront. Instead, as explained above, you receive a certain percentage of the invoice’s face value upfront. Then, the factoring company holds the remaining amount to cover its fees, and it may also hold a certain amount in escrow as a safeguard against potential lack of payment.

Some people choose to create a separate account for factored invoices. With this approach, you set up an additional accounts receivable section, and when you factor invoices you move them to this section. Then, you create an account named “factor advances.” In this section, you record all the money that you receive from the factoring company, as well as the funds your customers have paid to the factoring company. This account allows you to track the advances from the factoring company, plus the amount the factoring company has received from your clients. With most arrangements, you are responsible for repaying the advance if your customers fail to pay the factoring company.

At the beginning, the balance on this account is going to be negative. To explain, imagine the factoring company has advanced you $10,000. Then, the factor account should say -$10,000. If a client pays $2,000, the balance increases to -$8,000. As your clients repay their invoices, the final balance on this account works out to zero. But, this doesn’t take into account the fees and rebates just yet.

To explain how you should handle these numbers with double-entry bookkeeping, imagine that you have presented $10,000 in invoices to the factoring company. At that point, you debit your accounts receivables for $10,000, and you credit your revenue account for that amount. Then, the factoring company pays you 80% of the balance ($8,000). You credit that amount in your factor loan account. Then you debit your cash account for $8,000, and you also note any fees as a debit in your fees and interest account.

Now let’s say your customer pays $1,000 to the factoring company. At this point, you credit your account receivable for that amount, and you debit your factor loan account. Now, you have a $9,000 credit in your factor account. When your customer pays the remaining $9,000 balance, you debit the factor account, bringing that balance to zero. Then, you credit your accounts receivable. By this point, you have covered the $10,000 debt that you made to your accounts receivable when you originally made the invoice-factoring agreement.

Since your customer has paid the full balance, the factor company returns the remaining 20% of the balance to you ($2,000) minus the fees for the factoring service. Let’s say the fees are $500. You debit your bank account for $1,500, you credit your factor loan account for $1,500, and you record the $500 fee in your fees and interest account.

Alternatives to Small Business Invoice Factoring

In addition to invoice factoring, there is also invoice financing. Invoice financing works similarly to factoring: You work with a company that gives you a percentage of your unpaid invoices or accounts receivable. But, in this situation, you maintain control over your invoices. You contact your clients, and your clients pay you directly. They do not have contact with the factoring company. As you receive the payments from your clients, you repay the invoice financing company.

If you have very delinquent invoices, factoring companies may not want to work with you, but in these situations, you may be able to work with a collection agency. Some collection agencies work on your behalf. As they collect the funds, you pay them a percentage of the amount collected. In other cases, you can sell the invoices to a collection agency or to a law firm. Usually, this earns pennies on the dollar, and it’s significantly less than you would receive from a factoring company.

Although invoice factoring can be a useful resource in times of need, you probably don’t want to rely on this funding source on a regular basis. Instead, consider investing in cloud-based accounting software that can help you stay on top of your invoices and project your cash flow. Currently, 4.3 million customers use QuickBooks. Join them and get the support you need to watch your business thrive.