What is business factoring? What is invoice factoring? Advantages and Disadvantages

Business factoring or invoice factoring is a method for a business to increase cash flow by selling their account receivables at a discount for immediate money.

Brad Nakase, Attorney

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Business Factoring Example

Jane makes custom gold and silver jewelry which she sells online to customers. Unfortunately, Jane has been having trouble raising money to buy raw materials for her business. Part of the problem is that customers take almost two months to pay her for their purchased items. As an introvert, Jane does not particularly like contacting customers to ask about their payments. Therefore, she has contacted an invoice factoring company. She will send the unpaid invoices to this company, who will in return provide immediate funds for Jane’s business. The factoring company will deal with contacting the customers for payment, and Jane will have the money to go out and buy materials for her jewelry.

What Is Invoice Factoring?

As a result of unpaid invoices, a small business may suffer from low cash flow. Invoice factoring provides an easy and quick solution to this problem. It can be frustrating for business owners to wait for customers to pay off outstanding balances, and invoice factoring is a great option for businesses that need financing during this period.

This article will review the definition of invoice factoring and go over the advantages and disadvantages of this financing solution. This post should help a business owner determine of invoice factoring is the right kind of business financing for his or her company.

Invoice factoring increases cash with money that customers already owe to a business. In this way, this kind of financing differs from a business loan. The factoring payment process is simple to conduct, and is as follows:

  1. First, a business owner will sell his or her unpaid invoices to a factoring company. This company will pay a lump sum, which is generally between 70% to 90% of the invoice amount.
  1. After the business owner sells the invoices to the factoring company, the money will be transferred to the owner’s bank account. This money can be immediately used as working capital. This is a definite advantage because a business owner does not have to wait for a customer to pay his invoice to have usable money. He or she can instead receive money in a few days from an invoice factoring company. This prevents cash flow issues.
  1. At this point, the job of collecting unpaid invoices belongs to the factoring company.

One should keep in mind that the factoring company will charge a factoring fee for their services. This is typically a percentage of the invoice total.

However, even though there are benefits to working with a factoring company, there are also negative aspects. A business owner should study the pros and cons before committing to invoice factoring.

What Are the Benefits of Invoice Factoring?

As mentioned above, the greatest benefit of invoice factoring is the fact that a business owner receives the money owed to a business without having to wait for customers to pay. However, there are some other notable benefits to invoice factoring. These include the following:

Immediate Cash Flow

It can take months for a business owner to be approved for a bank loan. Even after approval, it can take a long time to actually receive the financing.

By contrast, invoice financing allows a business owner immediate access to cash. In some cases, a business owner can get funding on the same day he or she applies. This allows an entrepreneur to keep his or her business running smoothly without any disruptions caused by low cash flow.

This is a great option for businesses in the following financial situations:

  • The business owner has short term financing needs
  • The business owner has an emergency financial need and cannot wait weeks or months for loan approval
  • The business owner does not want to wait for customers to pay him or her back (this wait-period can sometimes extend from 30 to 90 days)

Ongoing Cash Flow

Invoice factoring can be used as a regular financing option, rather than a one-time option. A business owner can build a relationship with his or her factoring services company. In this way, it will never be difficult maintaining cash flow because the business owner won’t have to wait for invoices to be paid before getting money in his or her bank account.

Better Chance of Approval

When applying for a business loan, a company’s collateral, credit score, and loan history are all major factors in determining eligibility. However, these factors are not relevant when it comes to applying for invoice factoring. In general, the factoring company will mostly be concerned with the payment history of a company’s customers. Do they pay their debts? This will tell the factoring company how much risk they are accepting.

So, if a company’s credit score is low or it has other financial problems, a business owner can still purse invoice factoring for financing.

Ability to Outsource

It is difficult and time-consuming to keep track of unpaid invoices, as well as contacting customers about their debts. Because of this, it is easier and preferable to delegate this task to a factoring company. A business owner will thereby have more time to manage other duties and responsibilities, leaving the factoring company to contact customers for payment.

No Collateral Needed

The invoices themselves count as collateral, so a business owner will not need to offer equipment, real estate, or other assets as collateral.

Better Customer Relations

Debt collection is one of the more frustrating and difficult duties of a business owner. It is easy to feel like the ‘bad guy’ when asking customers for money. However, by giving this duty to a factoring company, a business owner can avoid negative reactions from customers. By not playing the ‘bad guy’ collecting debts, an entrepreneur can maintain healthy, positive relationships with his or her clients.

What Are the Disadvantages of Invoice Factoring?

There are some operational and financial disadvantages that come with using an invoice factoring company that a business owner should be aware of. These cons include the following:

The Cost

There are fees associated with using an invoice factoring company. Generally, a factoring company charges between 1% and 5% of the invoice amount for service fees. Because of this, a business owner must analyze whether it is worth losing this money in return for immediately available cash.

If a company is running on a tight budget, then it may make sense to wait for the customer payments to come in rather than paying fees to an invoice factoring company.

Liabilities

A business owner should know that he or she may be held responsible for unpaid invoices. Because invoice factoring companies do not function as collection agencies, they usually do not spend time hunting down late paying customers.

In the event an invoice factoring company cannot track down a late paying customer, the business owner will be responsible for paying the unpaid invoice. He or she may also choose to trade in a different invoice of the same amount to cover that cost.

Reliance on Customers

To determine a business’ eligibility for invoice factoring, a factoring company will study the customers’ payment history to calculate their risk.

If a business’ customers tend to pay their invoices late, then a factoring company will make the assumption that they will similarly not be paid on time. Because of this, they will be less likely to work with the business due to the enormity of the risk.

Lack of Control

To take advantage of invoice factoring, a business must hand over control of its invoices to a factoring company. This may be uncomfortable for some business owners, because they do not want another company examining their financial information.

Therefore, before a business commits to working with an invoice factoring company, the owner should ensure that he trust the company and its practices. Choosing a reputable and well-known factoring company should leave an owner feeling confident in the process.

How Is Invoice Factoring Different Than Invoice Financing?

Invoice financing, also referred to as accounts receivable financing, is when a business’ invoices are purchased by a lender. The owner of the business must then pay a percentage of the customer’s balance. The invoice financing company will then collect the customer’s payment. After the financing company receives the payment, the remaining amount is given back to the business. However, this amount does not include any fees.

Both invoice factoring and invoice financing can be useful for a company, but one method may make more sense depending on the particular situation or business. If a business owner wants more control over collecting unpaid invoices, then invoice financing may be the better option. However, if a business owner would prefer not to deal with contacting customers at all, then factoring would be the better solution.

Summary

Invoice factoring is a great solution for businesses that require easy and quick funding. However, there are also other kinds of financing for a business to consider, such as:

  • Small business loans
  • Merchant cash advances
  • SBA loans
  • Buisness credit cards
  • Lines of credit

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