Your office supplies business is thriving. With each sale of stationery, staplers, and printers, you invoice customers on terms requiring payment within 60 days. But lately, you’ve had trouble with your business financing because some customers are waiting until the last minute to pay, or even paying a bit late.
Now, even though you’ve sold a lot of goods, you don’t have the immediate cash flow to pay your employees, because you haven’t received your payments yet. What can you do? One way you can solve this problem is through invoice factoring.
What is invoice factoring?
Invoice factoring is the practice of selling a business’s invoices to a third party in exchange for a cash advance. This means the third party, often referred to as a factoring company, would collect the money from customers instead of the business owner. In exchange for the quick funds, factoring companies charge the business a fee of between 1% and 5% of the invoice amount. The practice is often used by companies that sell goods or services to other businesses because they are more likely to receive payments via invoices. Factoring is an easier way for companies to access funds, because factoring companies take into account the credit scores of a business’s customers, not the credit score of the business itself.
How does invoice factoring work?
To start the factoring process, a business owner will sign a contract with a factoring company, agreeing to sell its invoices, also referred to as the business’s accounts receivable. Then, the business owner will submit its invoices to the factoring company. The factoring company will pay the business between 80% to 90% of the invoice value to the business owner within a specified time. Usually, about a day or so.
Afterward, the factoring company focuses on collecting the invoice. Sometimes, if the customer is late on a payment, the factoring company will be responsible for reminding the customer and chasing down the funds. Once the customer pays the invoice to the factoring company, the factoring company will then pay the business owner the rest of the invoice balance, minus the agreed upon fee of 1% to 4%.
Sometimes, a factoring company will take financial responsibility for a loss if a customer fails to pay. This is referred to as non-recourse factoring. It costs more than standard recourse factoring, in which the business owner is responsible for the loss if a customer defaults.
Pros and cons of invoice factoring
Advantages of invoice factoring
There are several advantages to using invoice factoring for a business.
- Improved cash flow. The most obvious advantage of using invoice factoring is its ability to help with cash flow problems. Using a factoring company makes income more predictable and less volatile.
- Less stringent credit score qualifications. Invoice factoring companies look at the credit scores of the business’s clients, not the business itself. This can make it a useful alternative for businesses with low credit scores.
- No collateral. Unlike many loans, invoice factoring does not require business owners to pledge their real estate or inventory as collateral.
- Faster than most bank loans. It can take several weeks before the money from a traditional business loan is paid out. Most factoring companies will typically provide your business with funds within 24 hours.
- Less work chasing invoices. Many factoring companies will collect payments and chase down late invoices for the businesses that they serve. This can be beneficial to small business owners with limited time to spend on collecting invoices.
Disadvantages of invoice factoring
However, invoice factoring also comes with some disadvantages.
- Less control. Letting a third-party company take control of collecting payments can create more distance between a business and its customers. The factoring firm might be less personal or understanding of your customers.
- Hidden fees. Sometimes factoring companies include charges in the fine print of a factoring agreement that the business owner may not expect. This is why it is important for business owners to pay close attention to their contracts and understand all invoice factoring fees.
- Long-term commitment. Many factoring companies require business owners to agree to long-term contracts that last several years. If your business evolves and factoring is no longer needed, you could still be stuck in the contract.
- Not suitable for B2C businesses. Invoice factoring works best for businesses that sell goods and services to other businesses, often referred to as B2B businesses. Businesses that sell directly to a consumer, referred to as B2C businesses, usually do not issue invoices, so they cannot use invoice factoring.
- Customer credit risk. If your customers are deemed risky by the factoring company and have a history of paying late or defaulting, the factoring company may not approve your requests for immediate cash.
Invoice factoring vs. invoice financing
Both invoice factoring and invoice financing use unpaid invoices to secure immediate cash. Invoice financing is sometimes used as an umbrella term that covers all methods that use outstanding invoices to gain cash. However, sometimes invoice financing refers specifically to the practice of using invoices as collateral to secure loans while factoring refers to selling invoices to a factoring company in exchange for cash.
Use of invoices
- Similarities: Invoice financing and invoice factoring both refer to ways a business can extract value from its invoices before they are paid.
- Differences: Invoice factoring refers to the practice of selling invoices to a third party in exchange for quick cash, while with invoice financing the business can retain the invoices and be responsible for collecting payment.
Relationship with customers
- Similarities: In both cases, customers have a duty to pay their bills.
- Differences: Invoice factoring can change the relationship between the customer and the business because a factoring company is now in charge of collecting payments. With invoice financing, the business owners are still responsible for chasing down slow paying clients.
- Similarities: A business with invoices outstanding must meet certain requirements of a factoring company or the invoice financing company.
- Differences: Invoice factoring is usually easier to qualify for than invoice financing because it relies upon the credit scores of a business’s customers, not the business itself. This can be useful for a company with a limited operating history that has not had the time to build up credit.
- Similarities: In both cases, a business will incur fees when it uses a factoring company or an invoice financing company.
- Differences: Invoice factoring costs more than invoice financing because it requires the factoring company to spend time and effort chasing invoices.
Invoice factoring FAQ
What percent does a factoring company take?
The amount a factoring company takes depends on the creditworthiness of your customers, the number of invoices you have, and the value of your invoices. Typically, this rate is between 1% and 5%.
Is invoice discounting (a type of invoice financing) cheaper than factoring?
Invoice discounting is a type of invoice financing in which a business owner secures a loan using invoices as collateral. It is usually cheaper than factoring but harder to qualify for.
Who may provide factoring services?
Well-known factoring companies include altLINE, RTS Financial, and FundThrough. Some banks provide factoring services—you can check if your local bank does.