What is Invoice Factoring? Advice for Small Businesses

About 82 percent of U.S. businesses that fail do so mainly because of cash flow problems. Knowing what invoice factoring and its benefits is, could be the solution to your business’s cash flow crunch.

There are multiple reasons why a business would have cash flow challenges. One of the more common reasons is past-due invoices. Many small businesses bill their customers by sending them an invoice. If these invoices aren’t paid on time, you could end up with cash flow issues.

The good news is that there are financing solutions available to help business owners improve their cash flow, including small business administration loans.

Invoice factoring is another reliable way to limit cash flow issues. But what is invoice factoring? How does it work, and why should you consider it as a way out of your cash flow troubles?

These are some of the issues we discuss in this post. Keep reading to learn more.

What is Invoice Factoring?

Invoice factoring, also known as accounts receivable financing, refers to a financial transaction in which a company sells its invoices to a financing company at a discount. The lender is known as a factoring company. Factoring companies usually advance you between 80% to 95% of the invoiced amount. This advance is typically sent to you via a wire or an ACH transfer.

The cash you receive upfront for the sold invoices can help you cover the cost of your daily operating expenses. While invoice factoring is often listed as one of the financing options available for businesses, it is by no means a bank loan or any type of loan for that matter. Instead, invoice factoring is a transaction where you sell invoices to the factoring company in exchange for cash.

During this type of funding relationship, the factoring company is usually in charge of collection efforts. Invoice factoring is available to businesses of all kinds, including those in trucking, construction, manufacturing, medical equipment supply, and import-export industries.

How Invoice Factoring Works

Like most other business financing solutions, an invoice factoring relationship typically begins with an application. This application is similar to how you would apply for other types of funding. During the application process, you will need to provide basic information regarding your business.

Factoring companies take a keen interest in the quality of the invoices you are selling to them. If you are selling the invoices because your customers have problems paying you, the factoring company will be much less interested in purchasing the invoices than if your customers regularly pay their bills on time.

Once the factoring company approves you for funding, they’ll then send you an advance on the invoices you submit for funding. This advance is the percentage as defined in your funding agreement, which sometimes can be up to 95%. The amount you receive depends on the factoring company you’re working with and is also typically determined by the quality of invoices being factored.

The remaining balance not advanced to you will be sent to you once the purchased invoices have been paid. Keep in mind that there may be invoice factoring fees that will be deducted from the remaining balance being sent to you.

Recourse Factoring vs. Non-Recourse Factoring

What if customers don’t pay the invoice? The next course of action will depend on what kind of a factoring arrangement you agreed to.

If you agreed on recourse factoring, your business will be liable for unpaid invoices. If, on the other hand, you settled on non-recourse factoring, the funding company assumes total risk for the factored invoices. That means that your business won’t be held financially responsible for unpaid invoices.

Given that terms, advance rates, fees, and funding procedures can vary, it’s important to read the funding agreement thoroughly to make sure you understand it before signing anything. This way, you can manage your business’s finances safely and appropriately.

Benefits of Invoice Factoring

Why do so many small businesses decide to use a factoring company to fund their business? As a financing option, this type of funding has many distinct benefits. These include:

Fast Cash

Invoice factoring provides immediate working capital. This helps cover the cash flow shortage caused by customers who pay invoices slowly.

Customer Retention

Customers on long payment terms are often some of your most loyal. Instead of pressuring them to pay sooner, you can use invoice factoring to keep your cash flow healthy and continue to grow your business.

Easy Approval

Invoice factoring can help you get the funding you need when other lenders turn you down. For example, traditional banks may turn you down if you have poor credit, lack collateral, or have a limited financial history. Factoring companies don’t care as much about these things. They are more interested in the creditworthiness of the customers whose invoices you want to factor with them.

What to Do When Applying for Invoice Factoring

Now that you know what invoice factoring is, how it works, and how it can benefit your business, it’s time to look at a few essential tips you need to know when applying for this type of financing. Here are three of them.

Make Sure You Qualify

Before you start searching for a factoring company, you need to make sure that you qualify for this type of funding first. Keep in mind that you can only factor accounts receivable for services and goods that have already been provided. You’ll need to provide proof to the factoring company that the goods or services have been provided.

As we pointed out earlier, factoring companies will also want to make a decision on whether or not your customers are creditworthy before advancing you any cash.

Be Careful When Choosing a Factoring Company

While there are many factoring companies around the country, not all are created equal. Choosing the wrong one can result in you losing customers, money, and other inconveniences. Do research into the lender’s reputation, track record, fees, and advance rates before making a decision.

Read the Funding Agreement

Invoice factoring is different from other types of business funding that you may already be familiar with. The terms, advance rates, and fees can vary significantly from those of ordinary bank loans. It pays to read the funding agreement thoroughly, so you know what you’re getting into.

Consider Invoice Factoring to Help Increase Cash Flow

Hopefully, this guide has provided a good enough answer to the question: what is invoice factoring? As you have seen, this business funding solution can help you get your cash flow back on track when some of your customers take months to pay their invoices.

Would you like assistance with finding funding your business? Please fill out an application with us today!