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The Explanation behind the Working of Invoice Factoring

24th October 2012

The definition of invoice finance is really simple - it is just the process of raising cash by selling off some of the credit invoices of your company to a financier. The financier would then make payment to you immediately while the customers pay the financier later. This process is not only convenient but also very beneficial for businesses and therefore a majority of them are hopping on to the bandwagon and engaging in invoice factoring. This process involves selling the accounts receivable of a company at a discount to a third-party or external financing company.


By engaging in invoice factoring, a company can get fast prepayment against its sales ledger without incurring any extra cost. Thus, one can increase one’s working capital and also improve the cash flow of the company via this method. This method of invoice finance is generally not available to cash traders. Entities which offer this kind of facility may be independent organizations or subsidiaries of major financial institutions and banks. They would generally meet the business owner, visit their company, evaluate their business plan and also review the company’s financial situation before sealing the deal.


When invoice factoring starts, the credit limits of the company’s customers may be required so that the amount of invoices which requires factoring can be limited. If this is the case then both the parties, i.e. the company who requires invoice finance and the factor company need to agree on a common term of how the credit limits would operate. A typical factor generally agrees to pay an advance of 85% on the approved invoices immediately to the company. This initial payment is usually done within a day’s time. The balance of the invoices is paid when the debtors clear their debt.


Once the invoice finance process is fixed and the company raises an invoice which directs the customer to make payment to the factor directly then the company will need to send a copy of it to the factor. The factor then arranges for the agreed percentage of money on the invoice that they are supposed to pay to the company. The factor would then issue statements to the company’s clients or customers on behalf of the company. The mode of communication with the customers to be used by the invoice factoring organization has to be decided beforehand by the company.


After the customer makes 100% payment of the invoice to the factor directly, as this is the instruction given on the invoice, then the factor would pay the balance that is due to the company. This is how invoice factoring works and people get the invoice finance that they desire. Now, not all cases end smoothly, therefore sometimes it may so happen that invoices aren’t paid by the customers. In these cases, the responsibility for paying the debt would depend on the kind of agreement the two parties entered, i.e. non-recourse factoring or recourse factoring.


As far as the charges for invoice finance is concerned, there are two primary elements to the cost of an invoice factoring agreement. The first is a discount charge, which is basically the monthly interest that is calculated on the remainder of the funds drawn and the second is a factoring fee that is taken when the factor receives the invoice on behalf of the company. The truth is that factoring is quite a complex form of funding therefore it is advisable to obtain professional advice before going for this kind of process, especially if you have never done it before.

To understand how invoice factoring works, a strong recommendation would be to seek advise from a financial expert. The cash which is raised in this way is known as invoice finance and it has some elements to it which the taker should be familiar with.

Category : business/accounting/business/
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