As a small business owner there may be a time where you’re waiting to be paid from a customer, but you have to wait 30, 60, or 90 days for payment on invoices that are due. Invoice factoring is an option for these outstanding unpaid invoices.
Since every business owner has expenses to cover, in some cases you may need to cover the shortfall while you wait for payment from your invoices. Small businesses can reach out to an invoice factoring company to pay for the unpaid invoices and collect the amount from the customer for a fee.
The small business owner would get the cash he or she needs right away to continue doing business and the invoice factoring company would collect the needed funds. There are many supply and distribution circumstances where invoice factoring is helpful to maintain a consistent cash flow for a small business.
Is invoice factoring a loan?
Invoice factoring is not a loan. It’s a type of debtor finance where a small business owner sells its invoices (receivables) to a factoring company that covers the cash flow shortfall from the stalled or slow payment from the customers.
There are many types of companies that use invoice factoring, such as trucking companies, wholesalers, staffing agencies, and office supply companies. For example, trucking companies may face slow payment from shippers and brokers, sometimes taking over 60 days to pay an invoice.
Since trucking companies need to pay their drivers, cover the cost of food, and perform maintenance on freight trucks, they may use an invoice factoring company to purchase their invoices at a discount so they can afford to keep their trucking business running while their customer repays the funds.
Invoice factoring essentially covers a difference in budget cycles. While a small business may have weekly or monthly expenses to cover, some of its clients may have a longer billing cycle for payment of invoices.
How does invoice factoring work?
With invoice factoring, the small business will receive about 80% to 90% of its unpaid invoices, or accounts receivables, upfront. The remaining amount, minus the fees by the invoice factoring company, is paid once the customer completes its payment.
Typically, a fee for invoice factoring, which is also referred to as a factoring fee or discount rate, ranges from 1% to 5%. What’s unique about invoice factoring is that the company buys the small businesses invoices and then collects the debt directly from the customer. The invoice factor is risking not being paid, which is why they can charge more than other methods of invoice financing.
What’s the difference between invoice factoring and invoice financing?
With invoice factoring the invoice factoring company is responsible for the collection of the invoices from the small business’ customer. For invoice financing, the business owner is borrowing against the invoice amount and is still responsible for collection of the accounts receivables, even though a third party has financed the invoices.
Invoice financing is basically like a line of credit, whereas with invoice factoring, it’s a purchase of your invoices. With invoice financing the small business owner would repay the third party the invoice amount with fees and interest.
As a small business owner, you must also know if the invoice factoring company does recourse or non-recourse factoring. With recourse factoring the company will have the right to collect the debt from your business even if your customer doesn’t pay its invoice. Non-course factoring means that the factor will take on the risk and be on the hook if the customer doesn’t pay.
Pros and cons of invoice factoring
There are a few benefits of using invoice factoring. The first is that you get the cash your business needs to keep running without having to deal with the more rigid requirements of small business loans or lines of credit.
Secondly, the small business owner does not have to deal with seeking the collection of the invoice. When using an invoice factoring company, you do not have to worry about reaching out to the company; this is part of the service.
Invoice factoring is also less of a risk for small business owner because invoice factoring companies accept the risk of non-payment from your customers.
There are a few downsides, however. Invoice factoring is expensive and it can carry an unpredictable cost the small business owner. With interest rates up to 5% on the amount of your invoice, you’ll pay a high price as you wait for your customer to make the payment. The longer it takes for payment, the higher price you’ll pay in interest each month for your factor rate.
In some cases, customers may think a small business is in trouble if an invoice factoring company is obvious in its collection. Many invoice factoring companies try to offset this issue by being discreet in their collection methods.
How to find the best invoice factoring for your needs
Small business owners will choose an invoice factoring company based on a few factors including: the amount of the invoice, sales, and the credit score of the customer you’re collecting from. The customer must be credit-worthy in order for the small business owner to use invoice financing.
Before you sign an agreement, be sure to always read the fine print. Be aware that some invoice factoring companies charge different types of fees for the services. These fees can add up quickly and cause further cash flow problems for your business later.
By reading through your factoring agreement you’ll have a clear view of what it will cost you and when these fees may be incurred. If you have questions about the agreement, be sure to ask the invoice factoring company and review the terms. Don’t be afraid to evaluate and compare agreements to choose the best one for your small business.
You’ll also want to know what the invoice factoring company’s communication strategy is like with your customer. In some cases there will be direct communication and in other instances they may pose as your billing department. You will need to understand the company’s process and decide what works best for you and your customers.
How to apply for an invoice financing
In order to apply for invoice financing a small business owner will need identification, bank statements, credit score, and outstanding invoices. The process is often very quick and in many cases a simple online application. The invoice you seek to be purchased by the invoice factoring company is the most important aspect of the application process.
If you’re approved, once the process is complete, you’ll receive the business funds you need within a day. Some companies are able to connect directly to your accounting software.