Small Business Invoice Factoring: The Complete Guide

One of the biggest challenges you may face as a small business owner would be gaps in the business’s cash flow. This usually happens when customers are late on their payment.

Most businesses require outstanding invoices to be settled within 30 days after being issued but not all customers pay on time. Some may take as long as 180 days to settle the invoice.

This could create a huge gap in the cash flow of your business, leading to insufficient funds.

What is invoice factoring?

Invoice factoring is a business finance solution used when a customer is late on his/her invoice payment, or when there is a need to increase the business’s cash flow such as, to take on a large order or contract.

Here, you sell an outstanding invoice to a factoring company in exchange for a cash advancement equating to %80 of the total invoice’s value, that’s typically given within 48 hours after factoring the invoice.

At this point, the invoice is owned by the factoring company and therefore it’s their responsibility to collect the payment from the customer within 30 – 90 days. The remaining %20 (minus the factoring fee) will be paid once the payment has been collected from the creditor.

A practical example is when a hardware store issues a $12,000 net 30-day invoice to a business. What if the creditor fails to pay back the amount within 30 days or what if there is an emergency and you can’t wait long enough for the creditor to make the payment? How can you close such a gap in cash flow?

A bank loan is one option but then you will require a decent credit score and collateral of substantial value such as a vehicle or a home. On top of that, you will have to wait several weeks or even months to get the loan approved.

Invoice factoring, on the other hand, is a quick and efficient way to get the most out of your unpaid receivables. You will not need any collateral as well.

A factoring company may agree to buy the invoice for $11,640, considering there is a %3 factoring fee of $360. You will receive $9,600 (%80 of the invoice’s total value) within 48 hours after factoring the invoice.

The remaining $2,040 (%17 of the invoice’s total value) will be handed over once the payment has been successfully collected from the creditor.

Factoring fee

Also known as the discount rate, varies from %1 to %5 depending on the value of the invoice, volume of your monthly sales, customer credit score, and whether the factor is recourse or nonrecourse.

Types of factoring

There are two types of factoring; recourse and nonrecourse. In recourse factoring, if the customer fails to pay, you are liable to either buy back the outstanding invoice from the factoring company or replace it with another of same or greater value.

In nonrecourse factoring, you are under no obligation to pay back or replace the outstanding invoice if the factoring company fails to collect payment from your customer. Here, the factoring company is the one responsible for bad debt.

Nonrecourse factoring bears a higher transaction fee than recourse factoring due to the risks involved. It’s safe for you but risky for the factoring company.

How is invoice factoring any different from invoice financing?

Most people are confused about the two terms “invoice financing” and “invoice factoring”.

Unlike invoice factoring, where you sell an outstanding invoice to a factoring company in exchange for cash advancements, invoice financing lets you use outstanding invoices as collateral to get cash upfront while still having to be responsible for collecting debt.

In invoice factoring you are transferring the ownership of the outstanding invoice to the factoring company, letting them deal with the debt collection process.

This may sound great at first but certain customers may not like the idea of you sending companies after them to collect the payment rather than dealing with them directly yourself.

However, with invoice financing you are still responsible for collecting the payment from your customer. Downfalls are the time you have to spend on debt collection and the stress that comes along with it.

Another difference between them is the payment structure. In invoice factoring only a portion of the money, which equates to around %80 of the invoice’s total value is given upfront.

The remaining amount, minus the factoring fees, is paid after the factoring company collects the payment from your customer.

In invoice financing the full amount is paid upfront and you are required to pay it back in weekly or monthly installments.

As you can see, both invoice factoring and financing have their own set of benefits and drawbacks.

Benefits of invoice factoring

• Increases the cash flow of your business, thereby closing any funding gaps caused by late payments.

• Allows you to give loyal customers more time to pay for their purchases while still keeping the cash flow consistent.

• Easy approval process. Invoice factoring is great for small businesses that lack collateral, credit score or time in business to turn to traditional funding sources such as banks. Factoring companies only look at the value of the invoice and how trustworthy the customer is.

• Protection against outstanding invoices, especially in nonrecourse factoring.

• Debt collection becomes a responsibility of the factoring company, thereby freeing you from the stress that comes along with it.

• Helps you take on new opportunities in the market such as purchasing advance machinery or accepting a larger order.

• Helps you face immediate threats.

• Even at a slight loss, you are being assured of the payment.

Drawbacks of invoice factoring

• Some customers may not like the fact that you are using a factoring company to collect payments, especially if the due date is still to come. This could impact the reputation of your business.

• In addition to the factoring fee, there may be some hidden fees such as an application fee, processing fee, credit check fee and late payment fee. So be sure to ask them clearly what other fees are involved before you factor the invoice. But even with those fees, invoice factoring is still a good financing option for getting immediate cash.

• Although collateral or a good business credit score is not required, factoring companies may reject your invoice if the customer’s credit score is low. And it’s perfectly fair. Who would want to buy an outstanding invoice if the creditor has a reputation for late or missed payments? Another common reason for rejection is your monthly sales volume being lower than required.

• There is no guarantee that the factoring company will succeed in collecting the outstanding amount. If the factor type is recourse, you are still liable to buy back or replace the outstanding invoice with one that’s of equal or higher value. So unless you go for nonrecourse factoring, which is more expensive, you are still at a risk.

Conclusion

Invoice factoring is not the best choice for everyone but it can be a very useful lifeline to some. It’s a great solution if you need to raise capital fast without having to wait or go through the process of collecting the debts yourself.

Now that you know what invoice factoring is, when it is used, types of factoring, how it’s different from invoice financing and its pros and cons, you are ready to start your search for a reputed yet affordable factoring company.

Check whether the factoring company has positive reviews and whether they have won any awards for their services. It’s also worthwhile to check whether they are experienced in dealing with businesses in your industry to better understand your needs.

The bottom line is, if you want a fast and efficient way to raise money from unpaid receivables, invoice factoring is the way to go.

What do you prefer the most; invoice factoring or invoice financing? Why? Let me know in the comments section below.