What is Invoice Factoring and How Does It Work?
Does your company need cash now? It’s not unusual for successful small-to-midsize businesses to struggle with cash flow. That’s especially true for companies relying on large invoices with long payment terms. Do you know what invoice factoring is?
If you’re in that predicament, invoice factoring might be the answer to your problems. It can even help you get rid of that stack of unpaid invoices sitting on the corner of your desk. When you’re ready to hear how to turn your troubles into positive cash flow this month, read on.
What Is Invoice Factoring?
Invoice factoring is often referred to as “debt factoring,” or just “factoring.” It’s a process by which businesses sell unpaid invoices, aka accounts receivable, to a third-party known as a factoring company, or just factor.
The factor purchases the invoices for a percentage of their total value. The factor also takes responsibility for collecting the outstanding debts on the unpaid invoices.
The process has become an increasingly popular alternative for businesses with imperfect credit. These businesses struggle to find funding through traditional financing from banks.
How Does Invoice Factoring Work?
If you’re wondering how invoice factoring works, it starts and ends with the invoices. They act in lieu of your poor credit.
You must submit the details of your invoices to the factoring company. They decide if you’re eligible for a factoring disbursement. The factoring company assesses the loan risk and gives you their rates and terms in a factoring agreement.
If they send you a factoring agreement, you decide whether their loan proposal is reasonable. You avoid the hoops you have to jump through during a traditional loan, like releasing your profit and loss statements. If you don’t agree with the rates and terms of their factoring agreement, you can shop around with other factoring companies.
If you do agree, the factor will advance you the money. The factoring company will take control of your outstanding invoices and collect the outstanding debts from your customers. When they finish, the factor will pay out the remaining balance and subtract their fee.
In What Circumstances Would You Use Factoring?
One of the problems that businesses like yours face is maintaining working capital. Your invoice payment terms could be 60 or even 120 days long. Unless you have huge cash reserves, sustaining your business for an entire quarter without payment destroys your cash flow.
You fill this gap by maxing out your company credit cards and applying for business loans. The long-term result is a bank account swollen with overdraft fees and appalling credit.
You’re handing the responsibility of your accounts receivable to a third party. Losing control of tricky accounts may cause you to take a bigger loss in the long run.
This approach might reduce your chances of borrowing from other financial institutions when your credit improves. You’ll face greater losses than you would with low-interest loans from a traditional bank or other money lenders. When the third-party takes over the invoice collections, it may adversely affect your client relationships.
Factoring might give you better cash flow control. That’s especially true if you’re struggling to balance long credit terms for multiple clients.
Turning your invoice collections over to a third-party may improve your chances of repayment. These factoring companies are designed to gently prod even the most stubborn clients into action.
Equity investors cost more than invoice factoring and may put your business in jeopardy. Factoring payouts may adjust according to your sales. Since you don’t have to track down payments, you can spend that energy elsewhere in your business. You immediately transform potential capital into working capital.
How Much Does It Cost?
Just as with any loan or cash advance, costs vary. These are some of the considerations involved:
- The size of the company (your customer) with the invoices
- The estimated value of the invoices
- The state of the current economic market
- The amount of days for payment and invoice turnover
- The risk of recuperating investment from factoring invoices
- The risk for the lending partner (your business)
Each of these considerations is translated into a service charge. Those charges are used to calculate the factoring fee or discount rate. The factor may also add options like “credit protection” for additional fees.
What Is the Invoice Purchase Schedule?
Factoring lenders buy your invoices in two installments. The factoring advance, or first installment, covers approximately 85% of the invoiced amount of accounts receivable. Realize every agreement is different, and this is only an estimate.
When your clients pay their invoices in full, the factor pays you the final 15% of the invoiced amount. They subtract their fee from this amount. Here’s how it breaks down:
- Submit your invoices
- The factoring company sends you approximately 85% of the invoiced amount
- The client pays factoring company 30-60-90 or even 120 days later
- The factoring company sends you approximately 15% minus their fee
Though percentages vary, the two-stage advance typically stays the same regardless of which factoring company you use.
How Is Invoice Factoring Different than Discounting?
When you choose invoice factoring, you give a third-party control of your invoice collection and sales ledger. When you choose the discounting approach, you retain control.
Factors approach your customers directly for the settlement of your invoices. They also manage their own credit control. They may set up a separate bank account under your business name and contact your debtors acting like your billing department.
This approach maintains a sense of professionalism and may actually improve your business image with your customers.
Now that you better understand invoice factoring, you have some decisions to make. First, determine whether you have the invoices to qualify for a funding relationship with a factoring company. Then decide whether you can afford to trade an immediate gain in cash flow for a small loss of your invoice profits.
If you’re still considering other options, sign up to have other lenders lining up to compete for your business today.