Invoice factoring: What it is, how it works, and when you should do it

Thirty-five percent of small business owners skip applying for funding because they expect a denial, and for Black owners, that number is even higher (40%) due to concerns about bias. When traditional funding feels out of reach, your business needs alternative paths to liquidity — ones that don't depend on your credit score or a bank's approval.

Invoice factoring, also known as accounts receivable factoring, is a financial transaction where a business sells its unpaid invoices to a third party at a discount. Unlike a loan, this is an asset sale that lets B2B companies turn outstanding invoices into cash to manage cash flow or cover short-term expenses.

From replacing equipment to paying bills, running a small business requires money—but you may not always have the cash flow when you need it. Let’s explore how it works, the costs, and the pros and cons.

• How factoring invoices works
• How much does invoice factoring cost?
• Why do small businesses factor invoices?
• Invoice factoring vs. bank loans
• Invoice financing vs. invoice factoring
• Pros and cons of factoring invoices
• Should your business factor invoices?
• Is invoice factoring right for your business?

How factoring invoices works

When a business sells its unpaid invoices to a factoring company, it receives an upfront payment, usually a percentage of the total invoice value. The factoring company then collects the full payment from the customers, deducts a small fee for its services, and provides the remaining balance to the business.

Invoice factoring means a small business can turn its outstanding invoices into cash. Here’s how it works: 

1. Submit invoices: Your business submits the invoices you want to factor to a factoring company. 
2. Wait for approval: The factoring company will review the invoices to determine their eligibility and quote you a fee for their services. 
3. Get a cash advance: Upon approval, the factoring company pays you a certain percentage of the invoices upfront, typically between 80% and 90% of the total value.
4. Factoring company collects payment: The factoring company becomes the invoice owner, removing it from your balance sheet and taking responsibility for payment collection. This typically takes 30–90 days, depending on your customers' original payment terms (Net 30, Net 60, etc.). 
5. Collect remaining payment: After the factoring company collects payment for the invoices, it’ll pay you the remaining balance—minus any fees.

How much does invoice factoring cost?

Factoring companies turn a profit on your unpaid invoices by charging you a factoring fee—usually between 1% and 5% of the total invoice value. The exact fee will depend on the amount of the invoices and the creditworthiness of your customers.

Your specific rate depends on several variables:

• Volume: Higher monthly sales volume often leads to lower rates
• Customer credit: Factors care more about your customer's credit than your own

Recourse vs. non-recourse: This is a critical distinction in your contract:

• Recourse factoring (most common): You must buy back the invoice if the customer doesn't pay. This carries lower fees.
• Non-recourse factoring: The factor takes the loss if the customer defaults. Because the factor takes more risk, fees are significantly higher.

Let’s explore an example of invoice factoring using a 4% factor fee.

Example of invoice factoring

Say your small business needs $20,000 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 $25,000 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 $24,000 ($25,000 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 value: $25,000
• Fee (4% as an example): $1,000
• Initial cash advance (85% of the invoice after fee): $20,4000
• Remaining advance: $3,600 
• Total you’ll receive: $24,000

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: Small business invoice factoring does not require taking on additional debt, unlike traditional bank loans. 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.

Small businesses often struggle with late-paying clients, which can create a strain on their finances. If you want to streamline invoice factoring and better manage your cash flow, consider using accounting software.

Invoice factoring vs. bank loans

Invoice factoring is not technically a loan. A bank loan is money you have to pay back. Instead, with invoice factoring, a company buys your invoices in exchange for cash. Here's how the two compare across the factors that matter most to small business owners:

Approval process: Bank loans typically require a strong personal or business credit score, financial statements, and a lengthy underwriting process that can take weeks. Invoice factoring approval is faster, often within 24 to 48 hours, because the factoring company is evaluating your customers' creditworthiness, not yours.

Debt impact: A bank loan adds liability to your balance sheet. Invoice factoring does not, because you're selling an asset, not borrowing against one. This distinction matters if you're managing debt load or planning for future financing.

Flexibility: Bank loans come with fixed repayment schedules. With invoice factoring, you only factor the invoices you choose, when you need to. There's no long-term commitment or monthly payment to manage.

Invoice factoring services look at your customer’s creditworthiness more closely than your business credit. That’s because your customers are the ones responsible for repaying the debt, not you. 

For businesses that can't qualify for traditional lending or simply can't afford to wait, invoice factoring offers a faster, more flexible path to working capital.

Invoice financing vs. invoice factoring

Similar to factoring, invoice financing allows businesses to obtain a cash advance by borrowing against unpaid invoices. While they sound similar, they are fundamentally different. For many businesses, the choice depends on how much control they want to keep, and what the financing actually costs.

For many businesses, the choice depends on how much control they want to keep. QuickBooks Capital provides a middle ground for eligible users, offering business loans and lines of credit. You can use your QuickBooks data to simplify the application process, giving you the funding you need while you maintain your customer relationships.

Pros and cons of factoring invoices

Invoice factoring can work for small businesses needing immediate cash flow. However, it comes with other benefits like: 

• Quick access to cash: Because the application process is fast and requires minimal paperwork, small business owners can gain access to working capital more efficiently.
• Simplified approval: The approval process is less rigorous than a typical loan application process where lenders consider things like your personal credit score.
• No collateral needed: Unlike loans, invoice factoring doesn’t require any collateral, which can be beneficial for businesses with few assets. 

On the other hand, small business invoice factoring also comes with downsides. For example: 

• Cost: It can be more expensive than traditional bank lines of credit.
• Customer interaction: The factor contacts your customers directly, which may impact how your brand is perceived.
• B2B only: This only works for businesses that invoice other businesses. It is not an option for retail or direct-to-consumer models.

Also, note that invoice factoring services rely on the creditworthiness of the customers or clients who owe the invoices. If a client defaults or is unable to pay, your business may have to repay the factoring company.

Should your business factor invoices?

Growing businesses that don't have the time or credit to get a bank loan often turn to invoice factoring. It can help improve cash flow and revenue stability but can also help fund operations or pursue growth opportunities. It can improve cash flow and revenue stability, and also help fund operations or pursue growth opportunities. If your business has high profit margins and can afford to wait for customer payments, you may not need to look at options such as invoice factoring.

To qualify, most factoring companies require:

• A business bank account
• An Accounts Receivable (AR) aging report
• Invoices for completed work (not future work)
• Customers with a history of reliable payments

Some companies may also have industry restrictions, so look into their requirements before applying.

How to choose a factoring company

Not all factoring companies are created equal, so it's worth doing your due diligence before signing a contract. Here's what to look for:

• Fees and rates: Factoring fees typically range from 1–5% of the invoice value. Watch for hidden charges like application fees, monthly minimums, or termination penalties.
• Contract terms: Some companies require long-term contracts or minimum volume commitments. Look for flexible terms that fit your business needs.
• Recourse vs. non-recourse factoring: With recourse factoring, you're responsible if a customer doesn't pay. Non-recourse factoring shifts that risk to the factor, but it usually comes with higher fees.
• Industry experience: Look for a company that has experience working with businesses in your industry, as they'll better understand your invoicing cycles and customer base.
• Reputation and reviews: Check the company's Better Business Bureau (BBB) rating and look for reviews from other small business owners. A reputable factoring company should be transparent about its terms and responsive to questions.
• Advance rate: This is the percentage of the invoice the factor pays you upfront, typically 70–90%. A higher advance rate means more immediate cash in hand.

Is invoice factoring right for your business?

If your business is experiencing cash flow problems and you need access to immediate cash, invoice factoring can be a viable option. However, there are drawbacks and fees for accounts receivable factoring. The good news is that there are more small business financing options, like equipment financing and lines of credit, if invoice factoring isn’t the right fit for you. 

One of the easiest ways to prevent cash flow issues is to actively manage your accounts receivable. Accounting software like QuickBooks Online can help you track invoices and generate reports to monitor your financial health.