Invoice factoring: how it works and what it costs

How invoice factoring works

With factoring, the funder buys your sales ledger. Every invoice you raise to a business customer is assigned to the factor, which pays you an agreed advance against it and takes over collecting it. Your customers receive a notice telling them the debt now belongs to the factor and giving its bank details, and the factor’s credit control team sends statements, chases overdue invoices and logs disputes.

When a customer pays, the money goes to the factor. It clears what it advanced on that invoice, takes its charges and pays the balance into your account. Meanwhile each new invoice you raise adds to the cash you can draw, so the facility rises and falls with your sales without you asking for a bigger limit.

That last point is what separates factoring from an overdraft. A bank sets an overdraft limit from last year’s accounts. A factor sets its limit from this month’s invoices. A business whose sales have grown since its last accounts can draw against the larger ledger it has now.

Factoring is the form of invoice finance funders offer to smaller and younger businesses, because the funder controls the collection and sees each customer’s payments itself. It costs more than invoice discounting for the same reason.

From invoice to payment

1
You raise the invoice
You deliver the goods or finish the work, invoice the customer with the factor’s payment details on it, and send the factor a copy or upload it through its system.
2
The factor pays the advance
The factor checks the invoice against the customer’s credit limit and pays you the agreed percentage of its value. You can draw up to your availability at any time.
3
The factor collects
Its credit control team sends statements and reminders to your customer, chases overdue amounts and tells you about any dispute so you can resolve it.
4
You receive the balance
When the customer pays the factor, the factor deducts its advance and charges and pays the remainder of the invoice to you.

The terms in a factoring agreement

Advance rate: The percentage of each approved invoice you can draw. It is set for your business after the factor has read your sales ledger.
Service fee: The charge for running the ledger and collecting your debts, usually a percentage of the invoices you put through, sometimes with a minimum each year.
Discount charge: Interest on the money you have drawn, as a rate over a reference rate, charged daily until the customer pays.
Credit limits: The most the factor will fund for each customer. Invoices to a customer above its limit are collected but not funded.
Recourse period: With recourse factoring, the number of days after which an unpaid invoice is handed back to you to repay.
Minimum term and notice: How long you are committed for and how much notice you must give to leave. Leaving early can carry a termination fee.

What factoring costs over a year

Illustrative example

A company invoicing £1.2 million a year evenly to business customers who pay after 55 days on average. The advance, the rate and the fee are assumptions for the arithmetic: each factor sets its own.

Average unpaid invoices (£1.2m × 55 ÷ 365): £180,822
Average money drawn at an assumed 85% advance: £153,699
Discount charge on £153,699 at an assumed 9% a year: £13,833
Service fee at an assumed 1.25% of £1.2 million invoiced: £15,000
Cost for the year: £28,833

That is 2.4% of turnover. The service fee is the larger part here, and it pays for the credit control: set it against what it would cost you to employ someone to chase the same customers. The discount charge falls if your customers pay sooner, so a factor that collects well lowers its own charge. Compare offers on the total for your own turnover and debtor days, using the invoice finance calculator, and add any audit, set-up, bad debt protection and leaving fees.

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What your customers see

Your customers receive a notice of assignment telling them to pay the factor. That notice is what makes the assignment effective in law: section 136 of the Law of Property Act 1925 requires express notice in writing to the debtor. From then on the factor’s name and bank details are on your invoices and statements, and its team calls your customers’ accounts departments about overdue amounts.

If you are concerned that customers will read the notice as a sign the business is short of money, talk to your largest customers before the facility starts. The tone of the chasing matters to the relationship as well. Ask how the factor contacts customers, how often, and whether you can agree a protocol for your largest accounts before the facility starts.

Disputes still come back to you. If a customer says goods were faulty or the work incomplete, the factor stops counting that invoice towards availability until you resolve it. Keep delivery notes, timesheets and signed acceptance for every invoice, because those are what the factor asks for first.

Recourse and non-recourse factoring

With recourse factoring, you carry the risk of a customer not paying. If an invoice is still unpaid at the end of the recourse period, the factor hands it back and you repay what it advanced on it, usually by the factor deducting it from your next payments. If the customer becomes insolvent, the loss is yours.

With non-recourse factoring, the factor carries the bad debt risk for customers it has approved, up to the credit limit it set for each one. That cover is in effect credit insurance, and it is priced into a higher service fee. It covers insolvency of the customer: it does not cover a customer who refuses to pay because of a dispute over your goods or work.

Non-recourse makes sense when a few large customers make up much of your ledger and one failing would sink the business. If your customers are many and small, you are already spread across them and may be paying for cover you do not need.

Leaving a factoring agreement

Factoring agreements run for a minimum term with a notice period to leave, and a fee if you leave early. When you go, the factor still owns the invoices it has funded. It either collects them out, paying you the balances as they come in, or you, or a new funder, pay off what is drawn in one sum so the ledger can be reassigned.

Businesses leave factoring for two reasons: they have outgrown it and move to invoice discounting, or they no longer need the cash and move to an overdraft or nothing. Either way, read the termination clause before you sign: the notice period, the early exit fee and how the factor releases its charge at Companies House.

The funding search is for limited companies and LLPs, and for sole traders and partnerships borrowing more than £25,000.

Invoice finance cost calculator

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Questions people ask

How does invoice factoring work?

You assign your business invoices to a factoring company. It pays you an agreed percentage of each invoice when you raise it, collects the money from your customer and pays you the balance, less its charges, when the customer pays. The factor runs your credit control, and your customers are told to pay the factor directly.

How much does invoice factoring cost?

There are two main charges. A service fee for running the ledger and collecting the debts, charged on your turnover, and a discount charge on the money you have drawn, charged daily like interest. On top of these may come set-up, audit, bad debt protection and termination fees. Each factor sets its own rates, so compare the total cost for your own turnover and debtor days.

What is the difference between recourse and non-recourse factoring?

With recourse factoring, if a customer does not pay by the end of the recourse period, you repay the factor what it advanced on that invoice. With non-recourse factoring, the factor carries the loss if an approved customer becomes insolvent, up to that customer’s credit limit. Non-recourse costs more, and it does not cover invoices a customer refuses to pay because of a dispute.

Do customers mind if I use factoring?

Customers are told, because the law needs written notice for the assignment to take effect and the factor collects the money. Speak to your largest customers before the notice arrives. Agree with the factor how it will contact your key customers, and keep the paperwork for each invoice in order so disputes are settled without delay.

Can I factor only some of my invoices?

A factoring agreement covers your whole sales ledger. If you want to fund only particular invoices or particular customers, selective invoice finance lets you choose invoice by invoice, with no whole-ledger commitment, and charges a fee per invoice.

Finance is subject to status and to the lender’s terms. A personal guarantee makes you liable for the company’s debt if it does not repay, and it can be enforced against your own assets, including your home. Nothing here is a personal recommendation.

Invoice factoring

How invoice factoring works

From invoice to payment

You raise the invoice

The factor pays the advance

The factor collects

You receive the balance

The terms in a factoring agreement

What factoring costs over a year

What your customers see

Recourse and non-recourse factoring

Leaving a factoring agreement

Invoice finance cost calculator

Questions people ask

Working capital

Invoice discounting

Selective invoice finance

Invoice finance

Business funding for recruitment agencies

Invoice factoring

How invoice factoring works

From invoice to payment

You raise the invoice

The factor pays the advance

The factor collects

You receive the balance

The terms in a factoring agreement

What factoring costs over a year

What your customers see

Recourse and non-recourse factoring

Leaving a factoring agreement

Invoice finance cost calculator

Questions people ask

Working capital

Invoice discounting

Selective invoice finance

Invoice finance

Business funding for recruitment agencies

Start a funding search

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