Invoice Factoring: The Pros And Cons

Updated: Apr 8




Navigating and handling thousands of invoices demands precious time and can damage business’ cash flow. To collect payments and improve cash flow some suppliers use invoice factoring, which also is referred to as accounts receivable factoring or debt factoring. Invoice factoring is when businesses sell their receivables to a third party, called a factor. The factor pays nearly all of the invoice at once to the supplier, then collects payment straight from the buyer.

HOW DOES IT WORK?

The supplier sells either in part or full control of their accounts receivable. Afterwards, the factor is responsible for collecting the receivables. Below is an example:

1. A buyer makes an order at a supplier, which submits the invoice to the buyer.

2. The supplier sells the invoice to a factor.

3. The factor pays 70-90% of the invoice to the supplier after confirming that the invoices are valid.

4. The factor handles the debt from the buyer and collects 100% of the receivable.

5. The remaining amount of the invoice is paid to the supplier. The factor charges the supplier a fee for handling the debt collection.




WHAT IS THE IMPACT FOR SUPPLIERS?

Suppliers often send goods before receiving cash depending on the payment terms. Cash is normally received 30-90 days after the order is placed, but it depends on the industry and the agreed-on payment terms. By using invoice factoring, the supplier gets immediate payment. Below are the listed pros and cons of invoice factoring.

Pros:

1. Quicker access to cash Invoice factoring makes suppliers’ cash flow management easier and faster. Waiting is no longer necessary, and the cash can be reinvested immediately.

2. Creates a competitive advantage Making it possible to reinvest cash quickly creates a better opportunity to gain a competitive advantage. For example by preparing for the next sale and investing in value-driven activities.

3. Better relationship with customers Outsourcing the collection of payment to a third party lets them be “the bad guy” by reminding the customer of the payment agreement. Instead, the supplier can focus on their core business and build even stronger customer relationships.

4. Great for short-term funding Suppliers in need of short-term cash have great opportunities by using invoice factoring. The reason is factoring is often easier and cheaper than a bank loan. It doesn’t require a loan history, collateral, or credit score.

Cons:

1. Lack of control As a supplier, you give control over the payment collection to a third party. Their process of collecting payments might not meet your customers’ expectations. A factor can potentially act in an aggressive and cold manner to obtain the payment, which might lead to a damaged relationship and losing the customer in the long run.

2. Cost depends on your customer The fee is determined by your customer’s credibility. Factors determine the risk of late or non-payment - the higher the risk, the higher the fee.

3. Requires a certain number of buyers From a supplier’s point of view, economy of scale is more obtainable with many buyers. With more buyers, the complexity of improving cash flow increases. Therefore, the same benefit of factoring can’t be obtained with few buyers. From a factor point of view, they want to spread out the risk on as many buyers as possible. Hereby avoiding risk with a high concentration on few buyers.

4. Inflexible solution Factoring companies will try to commit suppliers for a longer period, which could be a year or longer. Suppliers need to evaluate whether the obtained value of faster payments outweighs the commitment to the factor.

WHAT IS THE IMPACT FOR BUYERS?

Buyers will be affected by the suppliers’ decision to use factoring to collect payments. A supplier should try to maximise the advantages for buyers as much as possible.

Pros:

1. Focus on buyers’ needs Less time used on collecting payments gives more time to focus on what matters to customers - allowing the supplier to establish better customer relationships or focusing on innovation development.

2. Faster access to new supplier innovation Suppliers’ quicker access to cash, allows fast reinvestment and increases the opportunity for faster value-driven developments. It enables the buyer to gain access to competitive new developments.

Cons:

1. Longer response time If a complication happens with the payment there is an intermediary between the buyer and supplier. Communication will be more complex as more actors are involved in the process. As a result, buyers can expect longer response time.

2. More complicated to return buyer’s money Sometimes mistakes and misunderstandings in business happen. Normally, returning money to buyers is troublesome in the first place, as often the value of not delivering on the agreed is subjective. To equalise the damage for the buyer, a supplier will usually deduct the value on the next invoice. When the factor is paid a % of the invoiced amount, involving a third party does not make the settlement process less complicated. This can cause the buyer to wait longer on their money.