Invoice factoring is a process of drawing funds against invoices. Invoice factoring nature and a process is similar to that of invoice discounting; however the main difference is that the invoice discounting is confidential while invoice factoring is not. Invoice factoring / discounting is a kind of working capital financing facility. This facility can ease the liquidity issues faced by small and medium-sized firms especially when debtor realization period is high.
The factoring process details may vary from one company to the other; however, the broad framework remains the same. The standard step by step invoice factoring process are as follows:
Invoice Factoring Process
Step 1: A company sells goods or services to one of its customers as per the agreed terms and conditions.
Step 2: The invoice for the goods and/or services provided is issued to the customer. After this, a copy of the invoice which needs to be factored is sent to the factoring company. It may be noted that the invoice sent to the customer usually has instruction for a customer to pay the value of the invoice directly to the factoring company. This is normally not the case in case of bill/invoice discounting.
Step 3: The factoring company then verifies the invoice and the background of the debtor. After the credit check, the company notifies the customers [debtors] about the payment to be made to the factoring company.
Step 4: The factoring company advances cash to the company usually within 24 hours. The percentage of advance given usually ranges between 80% to 90% of the invoice value and the balance is kept as a reserve payment and a part of it as its fee that is charged for convenience. The percentage of advance may depend on upon the credit comfort that the factoring company has on the debtor after it does the credit appraisal of the debtor.
Step 5: On the due date, the customer will make payment directly to the factoring company or the factoring company may arrange for collection from the customer.
Step 6: Upon receipt of the payments from the customer, the factoring company releases the balance cash after deducting the factoring fee. The factoring fee is usually the processing fee and interest charge based on the amount of invoice and number of days until the amount is received.
In cases where the payment is not made by the customer to the factoring company, two possibilities exist.
- If the factoring, when it was agreed upon, was “with recourse” to the company, the company will have to bear the credit loss by paying to the factoring house.
- If the factoring was with “non-recourse” to the company feature, the factoring company shall bear the credit risk and loss thereon.
Invoice Factoring Process Example
Let us assume that a company has sold goods worth $ 2000 to a customer, the proceeds of which shall be received 3 months from now. The company now wishes to undergo invoice factoring and approaches the factoring company. This is how the process and calculations shall look like.
|Cash Advance by factoring company (assuming 80%)(The balance 20% is kept as reserve, $ 400 in this case)||$1600|
|Amount paid by the customer to the factoring company on the due date||$2000|
|Amount charges by factoring company as interest and processing charge
(Assumed processing charge and interest cost together as 12% p.a. = 2000*0.12*3/12)
|Balance payment from factoring company ($ 400 balance less $ 60 charges)||$340|
|Total Amount received by the company ($ 1600 + $ 340)||$1940|
|Total Amount earned by the factoring company (the interest and charges)||$60|
Conclusion: The invoice factoring process is usually the same for most factoring companies; however it may change with respect to the percentage of drawdown, the credit check by the factoring company, the amount of paperwork and due diligence, the fee structure based on volume, the comfort between the company and the factoring company, etc. Invoice factoring is widely used by the companies and the process is quite simple and helps them in liquidity management.1,2