Invoice factoring, also known as accounts receivable financing, is a method used by companies to free up capital that is tied up in customer invoices. In invoice factoring, one company agrees to provide payment in exchange for the outstanding invoices that another company is owed. In this way, the second company gains the money it needs to pay its employees, pay its bills, and expand its business.
If a business needs to obtain owed money quickly, invoice factoring may be a viable option. Through invoice factoring, the company essentially sells the rights to outstanding invoices to another company for a rate that is less than the invoices are worth. In this way, the company selling the invoices gets a percentage of the amount owed on the invoice much sooner than originally anticipated. The company purchasing the invoices, on the other hand, makes a profit, as it waits for the invoices to be paid in full.
When attempting to complete an invoice factoring agreement, the company purchasing the rights to the invoices is generally willing to pay more for newer invoices. This is because older invoices are generally considered to be a greater risk, as there is a greater chance the customer will default on payment. While most companies pursue invoice factoring as a means to free up their capital and to receive payment sooner, some companies complete invoice factoring deals in order to avoid the risks associated with waiting for invoice payment. By transferring the default risk to the company purchasing the invoice rights, the company selling the rights can focus on completing current business activities and planning for the future rather than on collecting past-due invoices.
For businesses purchasing invoices through invoice factoring, working on collecting payment is not an issue, because it is generally the sole function of that business. Purchasing past-due invoices is not usually a risk for these businesses, as they are experts in collecting funds. Therefore, it is a win-win situation for both companies involved in invoice factoring.