One of the biggest challenges amongst business owners is finding the best ways to improve cash flow or deal with emergency expenses without applying for a loan or selling parts of the business.
As a business owner, there are many other ways you can pay your bills or access immediate cash when needed, and one of them is Invoice Factoring.
What is Invoice Factoring?
Invoice factoring (or account receivables) is a financial process where you can sell unpaid invoices to another company (a factoring company) so that they pay you on behalf of the customer, while they wait to collect the money from the customer when they’re ready.
This means that you no longer have to wait till your customer makes payment for an item or service before getting the money.
Think of the factoring company as a creditor that loans your customer the money for what they bought from you, and when the customer is ready, they pay the company back.
The factoring company immediately pays you between 70-90% of the money your customer owes. Then after collecting the payment from your customer, they take out an interest and give you the balance.
Invoice factoring is a great way to access immediate cash and let a third-party company deal with waiting and collecting payment from customers.
How Does Invoice Factoring Work?
The invoice factoring system can only work with companies that issue their customers invoices after work is done. Once a service is completed, you issue your customer an invoice that includes how much they will pay for the service and the time the payment is to be made.
If you need the cash faster than the payment period, there are three steps to follow:
- Apply to an invoice factoring company. After the company accepts your application, you identify the invoice you want to borrow against.
- The factoring company checks your client’s creditworthiness, and if they believe that the client can pay back, they give you about 70-90% of the money.
- You get your money, and leave the factoring company to collect the payment from your customer. Once your customer pays in full, the company removes an interest rate and pays you the rest.
An example is if you did a home renovation for your customer Greg for $4,000 and sent Greg an invoice, to be paid in 3 months. However, you need the cash to buy a new ladder, so you apply to a factoring company with Greg’s invoice.
The company checks Greg’s credit history, and if satisfied, they pay you 80% of the money, which is $3,200. After three months, Greg makes his payment to the company.
The company then removes an interest of 5%, which is $200, and sends you the $600 balance.
Eventually, you get $3,800 instead of $4,000 for not waiting three months for Greg.
Pros of Invoice Factoring
- Cash Flow Boost: One of the best advantages of Invoice Factoring is that it gives you immediate access to much-needed cash that helps you meet operational expenses, pay bills, or take advantage of growth opportunities without delay.
- Flexible Funding: Invoice financing is essentially not a loan because you are not borrowing money. You are paid according to your invoice amount, making it more accessible for anyone, especially when they have a low credit score.
- Quick and Easy Process: Invoice factoring is usually straightforward with minimal paperwork. Once you have settled with a reputable factoring company, you will be granted the funds in a matter of days.
- Credit Score Advantage: Your business's credit score might not matter as much in invoice factoring because it’s your client’s credit scores that matter.
- Risk Mitigation: The invoice factoring company is responsible for collecting payment from your customers, so you no longer have to deal with slow payment or non-payment cases. This is instrumental to helping you focus on more important things like growth and expansion instead of constantly following people up for payment.
Cons of Invoice Factoring
- Limited Eligibility: The invoice factoring model only works for businesses that issue invoices to their customers.
- Customer Credit History: While the creditworthiness of your business is not a factor, your customers must have a good credit history for you to be paid
- High-Interest Rates: The invoice factoring model has an average interest rate of 1-5%, which is higher than other types of loans.
- Extra Fees: Invoice factoring usually comes with additional fees due to factors like late payment, returned cheques, wired transfers, etc.
Factors to Consider Before Choosing a Factoring Company
- Market Focus: Most factoring companies have preferences for industries and business sizes, so it is vital to find the most fitting company for your business.
- Favorable Terms: Get familiar with company terms like the additional payment conditions, renewal processes, funding speed, etc., to get the best option for your business and avoid that will cost you money that you didn’t expect.
- Low-Interest Rate: The interest rate for the invoice factoring model is typically high, but you should find one closer to your financial bracket.
- High-Advance Rate: The initial payment you get can vary from company to company, so you should find one that gives you the highest possible amount as fast as possible.
Is Invoice Factoring a Good Solution for Your Business?
Invoice factoring particularly benefits businesses that usually have long payment periods, like manufacturing, wholesale, or service industries. It's also a great solution if in your line of business, there are times you need big cheques or you are expanding.
However, like any financial decision, conducting good research like comparing different factoring companies and understanding the terms and fees involved is important. Finding a factoring company that aligns with your business needs and goals is always the best.
Invoice factoring can be a powerful tool to enhance cash flow, improve financial stability, and fuel your business growth. Consider it a valuable option to grow your money and scale your business.