Understanding an Invoice Factoring Transaction

Factoring is rapidly becoming a common way to finance a business, especially now that business loans are difficult to get. It is a good business financing tool that can work very well for growing companies - or companies that have cash flow problems.

Invoice factoring is a specialized form of financing that is designed to help companies that have one very specific problem - they sell to their clients on net 30 to net 60 terms but can't afford to wait to get paid. Businesses find themselves with this challenge due to a number of reasons but the two most common reasons are poor capitalization or fast growth. As a matter of fact, fast growth is the main reason companies chose to do business with a factoring company. For example, a small company gets a very large order from a client. They can deliver it but can't afford to wait 30 days to get paid because they have their own expenses to cover. One option is to turn the sale away. Another one is to factor it.

So how does factoring help a company that can't wait 30 to 60 days to get paid? Simple - it provides a cash advance against those invoices. The advance enables the client to cover business expenses without worrying about the timing of client payments. The transaction is settled once the end customer pays the invoice in full.

Most factoring transactions are structured as an invoice purchase rather than a business loan. The factoring company buys the invoice from the client and pays for it in two installments. The first installment is called the advance and can be anywhere from 70% to 90% of the invoice value. The remaining part (10% to 30% of the invoice) is not advanced and used as a reserve to cover factoring fees and invoice discrepancies. The second installment, called the rebate, is provided once the invoice is paid in full. The amount rebated is usually the reserve, less any fees and payment discrepancies.

One of the biggest advantages of factoring is that is available to companies that have no hard assets (such as real estate) and little or no credit history. This makes it an ideal funding solution for small and medium sized companies that can't afford to wait up to 45 days to get paid by their clients.