One of the biggest challenges for any small business is inconsistent cash flow. This does not normally mean that your business is failing but does mean that your customers are not paying on time or you have to buy and pay for goods before you sell them on, which can be a challenge if a big order comes through.
When dealing with periods that have challenging cash flow, it’s worth knowing about established ways of dealing with this type of issue – and one of the most commonly used is invoice factoring or invoice discounting.
What is Invoice Factoring?
Invoice factoring is a finance strategy requiring you to sell your business’s outstanding invoices to a willing third-party establishment to generate revenue stability and increase cash flow.
In this instance, the third-party company may pay you the majority of the invoiced amount and proceed to collect payments from your customers directly.
While this may sound like the perfect way to improve cash flow, invoice factoring has advantages and possible disadvantages. You might also see invoice factoring referred to as debt factoring, asset-based lending or accounts receivable factoring.
When it comes to this finance strategy, credit scores or ratings are almost irrelevant. As a result, invoice factoring is perfect for new businesses or if you operate in a sector like logistics and staffing companies.
As the name implies, only companies that provide customer invoices qualify for factoring. If your business does not issue invoices, you should explore other financing options.
You can sell your accounts receivables in whole or part depending on what suits your business the best.
The process of invoice factoring is explained further below:
- You conduct transactions with your clients as you would typically and issue them an invoice for the services you’ve rendered.
- Apply to a factoring company that decides to either work with you or not.
- Identify the invoices you wish to sell for extra revenue and send them to the factoring company for vetting.
- Once approved, you can sell these accumulated invoices to the factoring company. You should do this if you’ve decided you need money faster than your client intends to pay you.
- The factoring company pays you in advance for the money you are owed. However, you will not get the total value of the invoices. Typically, these factoring companies pay between 80-90% of the value of the accumulated invoices.
- The factoring company then takes responsibility for collecting the cash equivalent of the invoice.
- Once the company receives the funds, they will pay you whatever is left minus their service charge.
There are instances where your business needs to explore invoice factoring. A typical situation is when your business has a shortage of funds because of accumulated outstanding invoices.
For example, if you offer services that do not require clients to pay instantly, you may need invoice factoring services often. As a growing business, you’ll have to deal with different clients, and some clients may require you to chase them for payments, while others may not. In situations like this, you may get to a period where the bulk of your business’s revenue remains trapped in places beyond reach.
With invoice factoring, you can release all of these funds or a large chunk of them for immediate use to repay a loan, carry out renovations, purchase raw materials or equipment, and more.
With invoice factoring, you get payments for your services in as little as a few days after rendering them. You can receive clients’ payments immediately. Also, you are saved from the hassles of chasing clients for payments. Access to quick funds allows you to plan and structure your business activities better. Furthermore, you can make better and have enough funds that will enable you to take advantage of opportunities that may come your way.
Invoice factoring is cheaper than bank loans. You can avoid paying interest, commissions and hidden fees. In addition, you’ll find it easier to access funds via invoice factoring than loans from banks and other lending institutions. Depending on the size of your client base, invoice factoring could be of enormous benefit.
With access to quick funds, you can invest more in ventures and purchase equipment that will help your business move to the next level. Lack of consistent cash is the primary reason why small businesses go under.
Invoice factoring may be a viable alternative if you have bad credit and are struggling to get loans from banks and online lenders. Factoring companies do not need to see your credit scores as long as your invoices are authentic and tenable.
Unlike other regular means of securing finance, factoring your invoices involves a straightforward process. Furthermore, you’ll be under less scrutiny when compared to your clients.
As long as your business falls into a particular category, factoring your invoices may take work. Factoring companies only work with companies that issue invoices to clients. If your business falls into a different category, you may find securing fast funds through invoice factoring challenging. Also, factoring companies prefer to work with businesses with a large client base. This is because they prefer to spread their risk net to be able to work with reputable and stable businesses only.
If your client base represents a high business risk, the factoring company may decide against working with you. If they proceed to work with you, you may be charged astronomical fees that will surely cut into your profits. Furthermore, if the process collapses and the client fails to pay for your services, the factoring company will require you to pay the money and the incurred charges. This will affect you and your business’s revenue significantly.
When it comes to invoice factoring, you will have to transfer some control over your customers to the factoring company. They are responsible for collecting the payments on your behalf. When it comes to this, some companies may go the extra mile to recover their money and ruin your reputation with your clients. While they may recover the pending payments, your customers may shift their businesses elsewhere.
While factoring companies are dedicated to helping get access to quick funds for your business, they’re also a business looking to make profits. Hence, you may find factoring companies wanting to take over your accounts receivables. Furthermore, they may want to tie you to lengthy contracts extending for as long as two years. This means invoice factoring is not a venture you rush in and out of. If you go into it, you may have to stay committed to it for a long time.
No two factoring companies are the same. Each company has its specialities, weaknesses, and strengths. If your company needs urgent financial intervention and wants to factor in invoices, you should consider the factors below before picking a factoring company.
As we’ve pointed out earlier, factoring will pay you the full advance on your invoices. In practice, these companies pay 80-90% of the total amount; hence, when choosing a factoring company, ensure that you pick the highest initial payment percentage. You’ll have more funds for your small business if you have access to a large chunk of the cash equivalent to your accumulated invoices.
Most cash advance services have online platforms customers can access whenever they want. Factoring companies should not be any different. When picking these companies, ensure that you pick one with a viable online presence. These websites should allow you to check the status of the invoices you’ve factored in. In addition, you should be able to factor in more invoices if you wish to do so.
Factoring companies are businesses; hence, they also want to make profits. While you should expect to pay charges for the services rendered, beware of hidden fees and costs. Reputable factoring companies will be transparent about the amount they charge for rendering their services to you.
The reason for employing invoice factoring services is to get access to quick payments. Hence, it is essential for the company you wish to work with to have the ability to release funds quickly. In ideal cases, you should get the cash advance in your business in a day or two after the company has approved your invoices.
Factoring companies specialise in specific industries. These are businesses that they are best suited for. So, when picking a factoring company, choose one with the right tools to help your particular type of business raise quick funds. This company must understand your business and your industry.
When you choose a factoring company, they should have the right tools to ensure a smooth and faster process of invoices. In other words, once a factoring company approves you and has also approved one of your clients, the process of factoring other invoices should be smooth and quick.
These terms are similar, but they have some key differences. For instance, invoice factoring requires you to sell your invoices to a factoring company. This company will also be responsible for collecting payments from your clients. In invoice financing, on the other hand, you have to send an application to a lender for approval to borrow funds equivalent to some invoices. As a result, you can get a cash advance on the money your client owes you. In this case, your business is responsible for collecting the payments from your clients. You can then use the money you’ve received to pay back the loan.
The first and most important thing you need is unpaid invoices from your most trusted clients. Next, you must complete a factoring application with a company of your choice. Your preferred company will analyse your account receivable (unpaid invoices, dates, credit memos, and money pending. This is a massive part of the paperwork needed to complete the process. Also, you’ll need a business bank account to receive the funds. Lastly, your preferred factoring company may need other information like Tax ID and personal identification documents.
Factoring companies would prefer that you factor all invoices through them but you can setup guidelines at the start – for example, invoices to a specific customer or type of product are not factored whilst all the others are. Your factoring company will focus on the invoices you choose to factor in based on your business needs and revenue requirements.
Invoice factoring is a fast and easy way to secure funds for your small business as long as it meets the factoring company’s requirements. However, you must be conscious of the disadvantages and challenges highlighted in this article.
As we’ve already seen, using invoice factoring to secure funds can generate some costs; however, if you run a reputable business, you can form a great alliance with the factoring for future businesses. It all depends on how you conduct yourself and how responsible your client base is.
Your chosen factoring company can be a guaranteed source of fast payment for goods and services you’ve sold to clients. This way, you can grow your company thanks to the continuous flow of cash at your business’s disposal.
Lastly, invoice factoring does not focus too much on your credit score so you can still secure cash advances against valid invoices with this strategy even if you have a poor credit rating.