Is Invoice Factoring Right for Your Business?
With invoice factoring services, you may turn your unpaid client bills into fast cash as a small business owner. This financing solution is appropriate for business owners that have other businesses as customers.
Because these consumers don’t always pay right away for goods or services, invoice factoring can help business owners keep paying staff and other expenses.
Here’s all you need to know about invoice factoring services.
What is invoice factoring?
Invoice factoring is not a loan in the traditional sense. Instead, you sell your invoices to a factoring business at a discount in exchange for a flat sum of cash.
The bills are then owned by the factoring company, which is paid when it collects from your clients, which usually takes 30 to 90 days.
Let’s imagine you own a hardware store and sell $10,000 worth of goods to another company. Your customer promises to pay its invoice in 30 days, but you need the money to pay your employees the next week. You’ve run out of money.
You could go to a typical bank for a loan, but you’ll almost certainly need excellent personal credit as well as collateral, which is a tangible asset like real estate that the lender may sell if you default. Perhaps you qualify but are unable to wait many months for the loan to be closed.
So you go to an invoice factoring services, which offers to pay you $9,700 in cash for your invoice – $10,000 less a 3% factoring fee ($300).
Within a few days, the invoice factoring company advances 85 percent of the invoice (or $8,245). When the invoice is due, the factoring business collects it and pays you the remaining balance ($1,455).
Invoice factoring example
|Initial advance (85% of invoice value after fee)||$8,245|
|Remaining advance (12%)||$1,455|
Depending on the invoice amount, your sales volume, your customer’s creditworthiness, and whether the factor is “recourse” or “nonrecourse,” the factoring charge, also known as the discount rate, can range from 1% to 5%. The factor type refers to whether your firm or the factoring provider is ultimately accountable for an unpaid invoice.
If the customer does not pay and the contract is a recourse factor, you may have to buy the unpaid receivable back from the factoring company or replace it with a more current receivable of equal or greater value.
You’re under no obligation to refund or replace the unpaid receivables if you employ a nonrecourse factor, but you’ll almost certainly be charged a larger transaction fee because the factoring company is taking on the additional risk of not getting its money back.
Invoice factoring pros
- Fast cash: Invoice factoring can help overcome a financial gap caused by slow-paying clients by providing instant working capital.
- Improved cash flow: You may keep loyal clients on longer payment terms while still increasing your cash flow to help your business expand.
- Easy approval: Because of a lack of collateral, low personal credit, or a limited operating history, invoice factoring can give capital to businesses that might not be able to receive it from other sources, such as a traditional bank. Factoring businesses are typically solely interested in the value of the invoices you want to factor and the creditworthiness of your customers.
Invoice factoring is an unsecured loan, which means you don’t have to put up any collateral, such as real estate or inventory, that the lender can seize if you don’t pay.
Invoice factoring cons
- High price: The service might be quite costly. Hidden fees, such as application fees, processing fees for each invoice you finance, credit check fees, or late fees if your client is past due on a payment, must all be considered. Late payments can result in an increase in your annual percentage rate, which is the total cost of borrowing money each year, including all fees and interest.
- Not suitable for all businesses: Because invoices are involved in transactions, invoice factoring is appropriate for businesses who work with other businesses. As a result, firms who sell to or deal with customers directly will not be eligible for this choice.
- Loss of direct control: Because the invoice factoring business may collect directly on the bills, you must ensure that your dealings with your customers are ethical and fair.
- Customers with poor credit or finances could cause your funding to fall through: Your customers’ creditworthiness may be verified by the factoring business. You may not be authorized for financing if your clients have a history of late or missed payments, or if your business has low revenue. Like other types of lenders, the factoring company expects to be paid back.
- There is no guarantee that you will be paid: There’s no guarantee that the invoice factoring firm will be able to collect on your overdue invoices. If the factoring company is a recourse factor, you may be required to purchase back the unpaid invoice or replace it with one of equal or larger value if it is a recourse factor.
How are invoice factoring and invoice financing different?
Factoring is not the same as invoice financing. Instead of selling your invoices to a factoring company, you use them as collateral to secure a cash advance, and you’re still in charge of collecting payment.