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If you are a small business experiencing rapid growth or are maxed out on your credit, you might consider invoice factoring. This type of financing enables you to increase your capital and cash flow. If you have creditworthy customers and don’t want the debt associated with a business term loan, invoice factoring might work for you. Read on to learn everything you need to know about how invoice factoring companies and services can help you get the business funding you need.
What Is Invoice Factoring?
Invoice factoring is when you sell your outstanding invoices to a designated company at a discount. That company then takes over collections for the invoices and you receive a certain percentage of those profits. Another name for this type of funding is accounts receivable factoring. A business that offers goods and services to other commercial businesses or the government often employs an invoice factoring company’s services for an instant surge in cash flow.
As a result, this form of financial help is accessible to both older companies and start-ups. Credit decisions are primarily based on the credit strength and history of a company’s customers. Unlike regular business term loans, which involve paying regular installments, invoice factoring supports and grows with a business’s sales revenue.
How Does Invoice Factoring Work?
To understand the dynamics of this type of financing, you have to look at the players that influence the process.
Factoring involves a business, its customers, the company’s outstanding invoices, and the services of invoice factoring companies. These companies buy outstanding invoices with payment terms of 30, 60, and 90 days.
Your business can establish an account with a company that offers invoice factoring services. When setting up an account, you turn over your outstanding invoices to the company, also called a factor. When you do this, the factor gives you an instant cash advance based on a pre-agreed-upon percentage.
Then, when your customers pay their invoices, the money goes into a temporary hold account. The factor, in turn, subtracts the fees and the advance they gave you in a lump sum payment. The company then wires the remaining balance into your business bank account.
An Example
Let’s pretend your company sells a product to another business and issues an invoice in the amount of $500, due in 30 days. In the meantime, your business signs an agreement with an invoice factoring service.
You sell the outstanding invoice, per the agreement, at an advance rate of 80% and a 2% discount fee. Therefore, your advance, or the amount you receive for capital, is 80% of $500, or $400. The factor takes $20 for its fee and deducts the advance of $400 when the customer pays. You receive the balance of $80, also known as a rebate.
The Pros
You will find that this type of alternative business funding offers several benefits, including:
Immediate capital
Invoice factoring allows you to realize an immediate cash flow, or increase in cash, using the money already owed by your customers. When businesses sell their outstanding invoices to factors, they receive a lump sum, normally between 70% and 90% of the invoice’s total.
The lump sum is disbursed electronically into a company’s bank account, giving you immediate access to working capital. Instead of waiting for the money over 30 to 90 days, you’ll receive the proceeds right away.
Quick approval
If you are a business with short-term financing needs, using invoice factoring services can serve you well. You do not have to wait weeks or months to get approved for financing, nor do you have to wait for customers to repay you.
Because your credit score is not used for this type of financing, you will find the approval process much simpler. Invoice factoring companies are more concerned with the payment histories of a company’s customers rather than their customer’s credit scores.
Continuing cash flow
Small business invoice factoring does not have to be a one-time funding option. Businesses can continue to do business with factoring companies if the funding makes sense for them. Cash flow continues because the business does not have to wait for its customers to repay their invoices per the invoice terms.
Streamlined financing
When your business uses invoice factoring services, you can outsource tasks like collection activities or credit checks.
No need for collateral
While you usually need collateral to finance a loan, your outstanding invoices serve as collateral when you use invoice factoring for capital.
The Cons
Although invoice factoring services offer some upsides, you also have to look at the downsides. The following information gives you some of the drawbacks of this type of financing.
Added costs
Fees for invoice factoring can limit a business. For example, factoring companies usually assess a charge of one to five percent of the total invoice amount for factoring. If you follow a tight budget, you may feel more comfortable waiting for your customers to pay.
It should be noted that processing an invoice on average costs about $10. While there are services that will add on a fee to their service, processing invoices adds up quickly, especially for small businesses.
Liabilities
It’s possible you’ll see an uptick in liabilities. You may have to pay for unpaid invoices or substitute other invoices for delinquent accounts to cover the costs of non-paying clients.
Less control
When you hand over control to a factoring services company, you may not like to share your company’s financial information so easily. If you choose invoice factoring to increase capital, make sure you work with a reputable and trusted business.
How Your Small Business Can Use Invoice Factoring Services
There are many reasons small business owners choose to use invoice factoring services. One of the main proponents is cashing in on pending payments.
If you have bad credit yourself but your business has regularly paying customers, you can maintain your operations by working with an invoice factoring services company. This form of business leveraging allows you to remove debt off your ledger and have the cash you need, delivered to your bank account. Use the money to stock inventory, pay off current debts, and stay on top of business expenses.
Invoice factoring vs invoice financing
If you have a small business, invoice factoring is one of the best ways to stay afloat. This innovative financial vehicle is distinguished from invoice financing, as it relies on the creditworthiness of a company’s customers. You don’t need to have good credit nor do you need collateral to obtain capital for your business.
While factoring represents a sales transaction, financing a business entails taking out a loan. Therefore, small business invoice factoring requires working with a company that features invoice factoring services. By taking advantage of the service, you don’t have to make recurring installments.
How Much Does Invoice Factoring Cost?
The main cost assessed for invoice factoring services is a discount rate, which spans from 0.5% to 5% of the invoice value monthly. What you pay will depend on your industry. Many invoice factoring companies use a tiered pricing program. The more invoices you factor in a month, the lower the discount rate. Thus, the more money you make on each invoice.
The discount rate is charged monthly or weekly. The amount of time for repayment factors in heavily in determining costs. The longer the invoice payment terms, the more discount rate payments are made. For instance, if you give your customers a term of 30 days, you pay the factor less frequently than you do for a lengthier invoice term, such as 90 days.
Hidden fees may include ACH fees, as well, or electronic payments for lump sum advances. The costs can span from $5.00 to $30.00. Some factoring companies charge credit check fees when reviewing the risks of a business’s customers.
Final Thoughts
Using invoice factoring services can prove profitable and increase your cash flow, provided you have customers who regularly pay their invoices on time. If you want to reduce the debt on your ledger and enjoy a better cash flow, invoice factoring may be a good solution for your business. Discover how these services can benefit your business’s growth.
