As a small business owner, at some point, you would have probably faced a shortage of funds when you had important expenses to cover. For instance, maybe you’d assumed that your customer would complete their invoice payment on time, and you could use those funds to cover your expenses. But your customer ended up paying late, and now you’re left short of cash. Bringing in funds just in time can be hard, especially when you’re just starting out. Maybe this is why you should give invoice factoring a go!
What is invoice factoring?
Invoice factoring is when a business turns over its outstanding invoices to a factoring firm in exchange for immediate cash. The firm pays an advance (a partial payment) as soon as you issue an invoice. Once they collect the payment from the customer, they will pay you the remaining amount, minus a small fee.
Let’s take the example of Melissa, a small business owner. A few months ago, she issued an invoice for $10,000 with 30 days as the payment term. Her customer paid the entire amount, but not until 3 days before the deadline. While she was waiting for the customer to pay, she noticed that one of her suppliers was offering a discount if she purchased raw materials in bulk, but the offer was only good for a limited time. Since she did not have sufficient funds, she missed out on the discount. Waiting for her customer to complete the invoice payment affected her expenses and cash flow. To improve her cash flow, she decided to try invoice factoring.
Now, she issues a similar invoice for $10,000, but she’s using invoice factoring. The factoring firm pays her an advance of 80% or $8,000 (advances typically range from 80-90%). The customer then pays the invoice amount within 30 days. The firm subtracts a service fee of 4% or $400 and gives her the balance. So Melissa gets a total of $9,600. While she didn’t get the entire invoice amount, she got an advance instantly. So her cash flow was good and she didn’t have to wait for it.
Eligibility criteria for invoice factoring
Invoice factoring works best for B2B and B2G firms that offer 30-90 days as payment terms. The paperwork required to sign up for invoice factoring varies from firm to firm. Typically, a business owner should provide financial records like accounts receivable aging reports, sales ledgers, a detailed list of customers and the corresponding outstanding invoices. Certain firms also ask for recent tax returns for surety.
To be eligible for invoice factoring, the business owner must:
- Meet specified thresholds for annual turnover and profit margin (varies for different firms)
- Have a good clientele with good credit history. Factoring firms are likely to be favourable if you have customers who pay on time.
- Have invoices already issued. Purchase orders and proposed invoices are not accepted by factoring firms.
- Have a clean background with impeccable tax records and no history of bankruptcy
How does invoice factoring work?
The invoice factoring process begins right when you invoice your customer for the goods or services that they have purchased. Then you contact the factoring firm of your choice, go through their application process (if you haven’t already), and sell them your outstanding invoices. Once you’ve cleared the screening process, the factoring firm will sign an agreement and set an initial amount which you can borrow as an advance.
In 1-4 business days, the factoring firm will pay you the advance, which is usually around 75-90% of the invoice amount. The advance amount is based on risk factors, your industry and the size of the transaction. Once your advance has been paid, the factoring firm will send your customers a notice of agreement about the invoice factoring.
When your customer pays the invoice amount, the factoring firm will subtract their factor fee and hand over the balance to you. The factor fee, also known as the discount rate, is essentially the cost of borrowing the advance from the factoring firm. It’s usually charged on a weekly or monthly basis, and it will be greater if the customer takes a long time to pay the invoice amount. The discount rate varies from 1% – 5% depending on the industry.
Before you sign up for invoice factoring, make sure you check out the pros and cons involved.
Advantages of Invoice Factoring
Beneficial for small businesses
Since it does not require collateral, invoice factoring is helpful for small and growing businesses or anyone who finds it hard to qualify for bank loans.
Quick access to cash
When you’re in need of immediate funds, invoice factoring is a good option. Invoice factoring is a fast process — it usually takes only 1-3 days for the factoring firm to pay the advance to the business owner. Even the initial screening process takes only about 7 business days at the most.
Improves cash flow and saves you from incurring debt
Invoice factoring can be a way to prevent the pile-up of debt and interest payments that can come from loans. Since the invoices are directly turned in for cash, it immediately improves the cashflow of the business. In the end, invoice factoring saves the business owner time and money.
Limitations of Invoice Factoring
Not receiving the entire invoice amount
When you use invoice factoring, you will always lose a portion of your payment. If you’re not ready to part with that amount and you’re prepared to wait for your customer’s payment, invoice factoring may not be your ideal choice.
Late payment by customers
When your customers pay late, the factoring fee adds up quickly. If a lot of your customers are tardy, invoice factoring can do more harm than good for the business and end up being more expensive than simply waiting for payment. In our example, the factoring firm subtracts their service fee of 4% of the invoice amount. While some small businesses might be fine with the factoring fee, 4% of the invoice amount is quite pricey and can be too much for some business owners. One way to avoid losing funds is to sell invoices selectively. Invoices issued to customers who’ve had a good payment history might be the best ones to sell to factoring firms.
On the whole, invoice factoring is a useful way to get timely cash. It’s easy to set up and gets you paid quickly. However, it’s advisable to weigh the pros and cons before venturing into invoice factoring. It can turn out to be expensive if your customers consistently make late payments, so make sure it’s right for your business before you sign up!