Approximately 82 percent of small and medium-sized enterprises fail due to cash flow problems. Of course, several factors can affect your cash flow. An aging accounts receivable or invoices that are past their due dates may account for a fair share of your cash flow challenges.
Luckily, there are financial tools and different forms of asset based lending you can use to manage your cash flow gaps. Invoice factoring is one excellent solution to your cash flow challenges if you’re a business owner with net 30, net 60, or net 90 terms with buyers.
Read on to find out whether invoice factoring is right for your business and how to compare invoice factoring vs line of credit.
What Is Invoice Factoring?
Invoice factoring is the financial solution commonly referred to as accounts receivable factoring. In this form of financing solution, a business sells their accounts receivables (pending invoices) to an external financing company (factor) at a reduced price. The invoice factoring company then makes cash immediately available to you.
Typically, the factor gives you approximately 70 to 90 percent of your unpaid invoices upfront, instead of you having to wait for 30, 60, or 90 days. Once the factoring company collects the dues from your customers, it pays you the rest of the money.
A factoring fee applies as payment for the factor’s service. Remember, invoice factoring is not a loan. It’s simply a quick way of generating cash today to cover the costs of your day-to-day operations or expenses.
How Does Invoice Factoring Work?
Although the procedure varies from one provider to another, it starts with your business applying for invoice factoring. This is no different from applying for any other type of funding.
So, how do small business loans work? Once the factoring company approves you for a factoring agreement, which typically takes about a day, you’ll have to submit your invoice to the factoring company. In exchange, the factor transfers the agreed cash to your business bank account within no more than two days.
The quality of your invoices and the invoice factoring startups you choose to work with determine the percentage of cash you get upfront.
The good news is that no interests apply to invoice factoring. It’s not a loan. The factor pays you the remaining amount minus the factoring fees once your customers pay their outstanding invoices.
Factoring companies will still welcome you if your business has poor or no credit. That’s because they’re more interested in your customers’ financial stability during the approval process. Therefore, as long as your customers have a reputation or solid track record of paying their invoices timely, chances of approval for invoice factoring are high.
Invoice Factoring Example
Let’s say you own a store and sell goods to another business on credit. If the goods are worth $20,000, you write them an invoice of this amount.
If your customer agrees to pay off the invoice in 60 days, but you need this cash in two weeks to cater for expenses such as paying your workers, it means you have cash gaps.
Now suppose you turn to invoice factoring, and the factor agrees to buy your invoice, you can expect the following terms:
- The company buys for $18,000 in cash.
- An invoice factoring fee of four percent applies. This amount equals $800.
- The factor deposits 80 percent of the invoice to your business account within two days. That’s $14,400.
- After the factoring company receives the payment from your customer after 60 days, it pays you the balance it owes you ($ 3600).
Pros and Cons of Invoice Factoring
Below are the advantages and disadvantages of invoice factoring for small businesses.
The benefits to invoice financing for small businesses include the following:
Invoice factoring can get you the money you need to run your day-to-day operations within two days. Unlike bank loans which can take a long time to approve and finance, you can receive same-day funding. That way, you can still improve your cash flow, helping your business grow while at the same time retaining your loyal customers who prefer longer payment terms.
Approval Is Easier
Poor or lack of credit, limited operating history, or lack of collateral can hinder you from acquiring funding from sources such as banks. Fortunately, invoice factoring can provide you with financing even in such situations. Factoring companies focus on your customers’ creditworthiness and the value of the invoices.
The invoices are enough collateral. So, you don’t have to worry about using your assets, such as inventory or real estate, as security for the funding.
Online invoice factoring has some negative qualities as well, which are outlined below.
The fee can be a limiting factor. A factoring company will charge an invoice factoring fee of one to five percent of your total invoice amount. This is a significant amount. You’ll need to consider if the tradeoff for instant cash is worth such a loss.
You leave it to the factor to collect on the invoices. That means you lose direct control of your customers. Always ensure the factoring company you’re working with is fair and ethical when handling your customers.
Eligibility for Invoice Factoring Largely Depends on Your Customers
If their payment history is solid, the risks on the factoring company’s side are low, and they’re likely to approve you. If the situation is the opposite, chances of the company taking you are slim. The risk might be too much.
Invoice Factoring Fees
Cost is a crucial factor when considering factoring as a source of your business funding. As mentioned earlier, you’ll incur a factoring fee of one to five percent. Negotiations about the percentage will revolve around several factors, including:
- The factoring company you choose
- The number of invoices you’re factoring
- Your industry
- Your customers’ creditworthiness
You may have to pay additional fees in addition to the basic factoring fee. These include processing, monthly minimum, ACH, application, and servicing fees. These costs also vary from one provider to another.
What Is the Difference Between Invoice Factoring and Invoice Financing?
The difference between invoice factoring and invoice financing is not significant.
You see, instead of selling your company’s invoices to a factor, you use your outstanding invoices as collateral, allowing you to get cash in advance.
Also, the responsibility of collecting invoice payments lies with you. Once your customers pay you, you’ll repay the lender the amount you owe them plus the agreed interest and fees.
No doubt, invoice factoring might be an ideal financing solution for a business line of credit construction. It will work well for you if you require fast funding for your business. Just remember there’s a fee you must pay upfront, and your clients must be creditworthy.