Invoice factoring is a term for the monetary transaction between a business entity and a factoring company. The factoring company purchases the outstanding invoices of the business at an agreed rate of discount.
1. Basics of Invoice Factoring
Invoice factoring is for businesses that follow a B2B model (selling to businesses, or the government). They can sell their invoices and access funds to boost cash flow.
A business loan is a complex financial contract. It is a tedious process and creates debt on your ledger. On the other hand, invoice factoring is simple. You sell uncollected invoices to a factoring company.
You do not need to wait for thirty to ninety days for the money owed by your debtors to your business. The money you receive as an advance against this sale can augment your working capital.
The factoring company charges a fee for this service, which is a percentage of the outstanding invoice amount. Collecting the invoices on their due dates is the responsibility of the factoring company.
2. Process of Invoice Factoring
There are four important elements in the process of invoice factoring. These are:
- A business in need of short-term capital.
- Debtors who owe money to the business against purchases.
- The invoices outstanding to the business by the debtors.
- A factoring company.
The entire factoring process explained here:
- Your business sells products or services to other businesses. You issue invoices to these businesses that are due in the time agreed upon (usually 30 to 90 days).
- You set up an account with a factoring company. This is a one-time task.
- You sell your outstanding invoices to the factoring company.
- The factoring company advances your money against the purchase of invoices based on a rate agreed upon between the two of you.
- Your debtors make the payments due against the unpaid invoices.
- The payment goes into a reserve account opened by the factoring company.
- The factoring company discounts the amount previously advanced and factoring fee. They wire the balance amount to your bank account.
3. Pros of Invoice Factoring
Some of the specific benefits of invoice factoring are:
Responsive and simple
Whether you apply for a business loan or any other financing option, it is a long-drawn process that might take weeks or even months. Even after all the paperwork and approval, receiving the actual funds may involve more delays.
Invoice factoring is a simple and hassle-free means to fulfill your urgent cash-flow needs and run your business smoothly. It is a feasible alternative for the short-term working-capital demands of your business.
If you are engaged in a kind of business that has seasonal or intermittent peaks and troughs, invoice factoring can continue to be a financing option. Additionally, you may want to avoid the hassle of short-term debt on your ledger.
It may make sense for your business to build continued relations with a factoring company. This will take care of problems with trying to maintain a steady cash-flow without waiting for the unpaid invoices.
Your credit history, collateral, or your loan history do not greatly affect your chances to access funds through invoice factoring. The factoring companies are mainly concerned with scrutinizing the payment history and creditworthiness of your customers.
With this, they can weigh the risks they are taking when they purchase your invoices. Invoice factoring becomes a suitable alternative if you have low credit scores or there is any kind of delinquency in your financial history.
It consumes a lot of time to keep track of uncollected invoices and follow up on debtors. Letting someone else do it for your business ticks off a major task from your list and can save you a lot of time and headache.
The fee you are paying for invoice factoring not only provides you the much-needed cash-flow but also outsources the bulk of your A/R work. You can have more time at your disposal to handle other immediate concerns of your business.
Collecting outstanding payments from your debtors is an onerous task. It can prove to be difficult and frustrating in the best of times. When you hand over this burden to an invoice factoring company, you can focus on building more positive relations with your clients.
You can also afford to be liberal with the credit terms without stretching yourself financially – but only if you have confidence in the creditworthiness of your customers.
4. Cons of Invoice Factoring
Some of the disadvantages that come with invoice factoring are:
Costlier than traditional bank loans
Any kind of financing comes at a cost, some more so than others. Raising short-term funds through invoice factoring is more expensive as compared to a traditional bank loan. Service fees of an invoice factoring company can range from one to five percent of the invoice amount.
You should opt for invoice factoring only if your need for urgent cash outweighs the costs incurred. If the returns on investments (ROI) in your business are low, it might be prudent to wait for the receivables rather than pay added costs.
Liability for bad debts
Invoice factoring companies run checks on the creditworthiness of your customers before allocating funds to your business. But the responsibility for any unpaid invoices still lies with you.
The factoring companies are not likely to follow up on late payments or delinquent customers. You will be liable to pay for any bad debts or trade-in additional invoices, based on the terms of your agreement with the company.
Reliance on customer’s track-record
The factoring companies investigate your customers’ past payment records before getting into a business agreement with you. They will be reluctant to take on the invoices if the past record of your customers is dubious.
Based on this, your customers’ bad payment history might result in a higher service fee by the company to cover the extra risks.
Less control over customer interactions
The factoring company has absolute control over your invoices and accounts receivable department. As a business owner, you might not be comfortable with another business accessing information about your customers and finances.
Trust plays a major role in this process and you will need to select a reputable and trustworthy factoring company to do business with.
Only for B2B companies
Invoice factoring is available only for a business selling to another business or to a government entity. This facility is not for retail or other businesses that sell directly to consumers, or the B2C category.
5. Cost of Invoice Factoring
Typically, factoring companies charge two types of fees:
The administrative fees describe various fixed administrative charges that may vary for different factoring companies. These generally include:
- A one-time account set-up fee for appraising the debtor’s credit history and background.
- A funds transfer fee or wire fee for wiring funds from the reserve account to your account. This is mostly levied once for the total amount wired to your account and is typically around $25.
- A minimum volume fee if you are unable to meet the target to sell a fixed amount in invoices, as per the agreement between your business and the factoring company.
Invoice factoring charges vary depending upon invoice volume and the creditworthiness of your debtors. The monthly fee can range from one to three percent with additional charges every ten days after that.
6. Invoice Factoring vs Bank Loans
Bank financing, if available, should be the first option for any business. Bank rates are much cheaper than other forms of financing. But to qualify for a bank loan, your business needs to meet all the criteria. Additional paperwork and requirements are also time-consuming.
If your cash flow requirements are short term, or even urgent, factoring could be the solution for your business. You can tap into an added source of cash without adding debt to your ledger.
7. Invoice Factoring vs Invoice Financing
We have already learned all about invoice factoring. Let us find out what invoice financing is, and how it differs from factoring. In invoice factoring, your business gets an advance for selling the invoices at a discount. Invoice financing is a secured loan based on your invoices. You can secure a part of your business’s accounts receivable, as a loan. Invoice financing creates a debt on your ledger, with your invoices as collateral.
Both factoring and financing of invoices have their benefits. You will need to decide which one is better for your business, based on your requirements and your business goals. Invoice financing puts you in charge of the collection of payments from your customers. But if you want to save time and effort in contacting your customers for outstanding payments, factoring is the option for you.
Is invoice factoring for you?
Different financial solutions work for different businesses. As a small business owner, you need to be aware of your options and should make an informed choice that suits your business. Bank loans, SBA loans, and cash advances are some of the options you can explore before deciding what is best for your business. Invoice factoring is for businesses that need an urgent boost of working capital, have creditworthy customers, and can pay the higher fees.