Understanding Invoice Factoring Concepts and Terminology You Need to Know
More and more small and medium-sized businesses are pursuing alternative funding options to support operations, weather harsh economic conditions and prepare for growth opportunities. Invoice factoring is a mainstream business financing solution to quickly access the money your business needs when you need it.
If your business has creditworthy customers, invoice factoring is fast and easy to qualify for, simple to manage, and has minimal lender oversight to provide maximum flexibility.
Whether you’re searching for a new invoice factoring partner or reevaluating the services of your current factoring company, know how to have an informed discussion. It’s essential to understand the basic concepts and terminology to efficiently research providers, their services, to make the best funding decision for your business.
The concept of invoice factoring
Invoice factoring is very simple. It is the selling of accounts receivable invoices at a discount in exchange for immediate payment.
This reduces days sales outstanding (DSO) and expedites the cash conversion cycle. Most importantly, it allows businesses to rely on predictable cash flow, stay current with bill payments, and support the ongoing costs of doing business.
How invoice factoring works
Let’s begin with an understanding of the main components of an invoice factoring arrangement.
There are three key parties involved in a factoring agreement:
- Client business: The seller of invoices
- Account Debtors: The business’s customers who make invoice payments
- Factoring company: The lender who buys invoices and advances cash
There are three main financial transactions involved with each invoice financed:
- The advance: The amount transferred to the client’s business account within hours of the factoring company receiving and verifying the invoice. Typical advances range from 70% to 95% of the invoice face value.
- The reserve: The remaining balance due, held back by the invoice factoring company until they receive full payment for the invoice total.
- The factoring fee: The factoring company charges a factoring fee for its services. The fee is deducted from either the advance or the reserve amount.
Following are the steps to complete the funding process with invoice factoring:
- Once goods or services are delivered, send a copy of the invoice, PO confirmation, and proof of delivery to the factoring company.
- The factoring company will verify that the services or goods have been delivered as per the PO.
- Once the factoring company approves the invoice, advanced funds (up to 95%), minus the factoring fee, will be transferred to the business’s cash account. The advance can be transferred the same day if the request is made early enough in the day to allow processing. Otherwise, advance payment will be made within 24 hours.
- The remaining balance due is held as the reserve. When the invoice is paid in full to the factoring company, the reserve is released and transferred to the business’s cash account. This completes the funding process for each invoice submitted.
Now that we’ve defined the key parties involved, transactions, and processes of an invoice factoring agreement, let’s dive into the terminology you need to know to understand and discuss the invoice factoring journey.
Invoice factoring terminology you need to know
The following is the key terminology you need to know to have an informed discussion about invoice factoring.
Account Debtor: Also known as the client business’s customer – a company that purchases services and remits payment of invoices the client business’s factoring company.
Accounts Receivable (A/R): Outstanding money that is owed to the client business by their customers (account debtors). This money is usually in the form of an invoice due to be paid in a certain period.
Accounts Receivable Factoring: Another terminology for invoice factoring, or accounts receivable financing.
Advance: The amount of money the factoring company advances to the client when they buy their invoice. It’s usually a percentage of the gross invoice value and is advanced to the client soon after the invoice is purchased.
Advance Rate: The percentage of the invoice that will be advanced to the client. This rate often varies between 70% and 95% of the gross invoice value.
Bad Debt: Debt that’s unlikely to be collected. Unpaid invoices (an example of bad debt) are often paid out to the factoring company from the client’s reserve account and returned to the client business.
Client: A company that sells its invoices to a factoring company. Don’t confuse this with the term “customer.”
Closing Costs: Costs involved in becoming a factoring client. Some factoring companies have no closing costs. Other factoring companies charge the cost as a percentage of the total factoring line amount. The closing costs are also referred to as the setup costs.
Collections: Payments that the factor receives for invoices factored by the client.
Concentration: The maximum amount for which a factor will fund a single customer (account debtor) in a client’s portfolio. This is often expressed as a percentage of the factoring volume for a given customer. Concentration is used as a risk management measure to ensure that a single customer does not represent a large majority of a client’s portfolio.
Credit Limits: The factoring limit that is placed on each of a client’s customers by the factoring company. This is usually determined by assessing the client business’s customers’ creditworthiness.
Credit Protection: A facility that covers the client against potential losses for unpaid invoices. Usually in the form of a credit insurance policy.
Credit Terms: A commercial sale that allows the customer to pay within a certain number of days after an invoice is submitted.
Current Account: The total amount of funds paid to a client, including any charges at any given time.
Customer: A company that purchases products or services from the client business and remits payment of invoices to the client’s factoring company. Also known as the account debtor.
Day Sales Outstanding (DSO): A calculation used by a company to estimate the average time it takes their customers to pay.
Dedicated Account Manager: A client’s main contact with a factoring company and the manager of a client’s factoring account. A factoring company uses a dedicated account manager to build a relationship with the client and streamline the funding process.
Disapproved: When the funding of an invoice is not approved.
Dispute: A situation where the account debtor does not pay an invoice due to a problem with the service or invoice.
Factoring: A commonly used shortened terminology for invoice factoring.
Factoring Agreement (Factoring Contract): A formal contract issued to the client that states the terms of the factoring agreement.
Factoring Company: A company that provides factoring services.
Factoring Fee: The fee the factoring company charges to finance a client’s invoices. This fee is usually a small percentage of the gross value of an invoice.
Funding Limit: The maximum amount of money a factoring company can fund to a client’s account.
Funding Period: The time period from the purchase of the invoice to the customer paying the full invoice amount.
Invoice Discounting: Another term for factoring.
Invoice Factoring: Another term for accounts receivable factoring.
Non-Notification: A form of factoring where the client’s customers are not notified that their payments should be paid to a factoring company. In this situation, the customer believes they are paying the client when they are actually sending payments to the factoring company.
Non-Recourse Factoring: A form of factoring where if a client’s customer doesn’t pay, the factoring company will absorb the cost. Most factoring companies that provide non-recourse factoring are only willing to absorb the cost if the client’s customer files for bankruptcy or declares insolvency.
Notice of Assignment (NOA): A notice sent to customers notifying them that the client’s invoices should be paid to the factor.
Notification: The process where the factor legally notifies a client’s customer that payments for the client’s work should be made to the factoring company. This is usually done through the sending of an NOA.
Rebate: Also called the “reserve.” The balance owing that’s paid to the client when the client’s customer pays the invoice.
Recourse Factoring: Recourse factoring is the most common form of factoring where if the client customer doesn’t pay, the client business is responsible for buying back the invoice from their factoring company.
Reserve Account: A client account where a small amount of each factored invoice is deposited. This is usually used as insurance to offset the cost in case one of a client’s customers doesn’t pay their invoice.
Reserve Amount: The percentage of the invoice that is deposited into the reserve account.
Recourse Period: the time that a factoring company allows for the account debtor to pay an open invoice that the factoring company has funded.
Same Day Funding: Receiving advance payment on invoices within the same business day of submitting an invoice for funding.
Schedule of Accounts: It’s a form that the client uses to submit their invoices to their factoring company for funding.
UCC: The Uniform Commercial Code (UCC) is a financial document used between businesses that are lending and borrowing money. It is a uniform act harmonizing the law of sales and commercial transactions in the 50 states.
Verification: The process of checking an invoice’s validity, amount, and payment address prior to being funded. This is usually done through a phone call with a client’s customer.
Working Capital: The capital of a business that is used in its day-to-day trading operations, calculated as the current assets minus the current liabilities.
Understanding the key concepts and terminology of a factoring arrangement allows you carry an informed discussion when conversing with an invoice factoring company. This level of communication will help to assess the features and benefits each provider offers and positions you to better negotiate the terms and conditions of a factoring agreement.
When searching for a factoring company to be your trusted financial partner, look for a lender that has experience in your industry, is straightforward and transparent when explaining their services and costs. The factoring company’s integrity, and clarity of purpose in everything said and done should be a defining characteristic of a trusted partner. Look for a lender that speaks candidly, responds informatively to questions, and commits to dependable service you can count on. Clear communication and trust are key elements to a successful partnership.
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