What is Invoice Factoring and How Does it Work?

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Cash flow can make or break your entire business operation. Getting paid fast and on time allows you to grow your business and pay bills. So your business is limited while you are waiting for your invoice to be paid. 

Getting money from banks or traditional loans can take a very long time and be burdensome. So where else do you go to get quick money while you’re waiting for your invoice to be paid? In comes invoice factoring. 

With invoice factoring, a business can get immediate cash advances on every outstanding invoice. Learn more in the following paragraphs.

The Basics of Invoice Factoring

Factoring your invoice means selling ownership of your accounts receivable (invoices), either in part or in full. 

The invoice factory procedure is quite simple: you sell your outstanding invoices to a third party (a factoring firm that pays a lump sum, this is typically between 70 – 90 percent of the total invoice). The money sent can be forwarded straight to your business account to be immediately used as working capital.

This is so beneficial to businesses because rather than having to wait for as long as 30 to 60 days for payments to your business, you can receive this money in a matter of days from an invoice factoring firm.

Another thing to note is that the factoring company will charge a factoring fee for the service rendered. This is typically a percentage of the invoice amount. The responsibility of getting the outstanding invoice will be shifted to the factoring company (terms and conditions apply, be sure to check).

While it can be advantageous for small business owners to partner with an invoice factoring firm, some drawbacks come with it. Before applying for invoice factoring, you can consider the pros and cons, so keep reading to see if this is the right choice for your company!

Examples of Invoice Factoring

Here’s a super simple example.

You’ve just sent your client Starks industries an invoice for $200,000, payable in 60 days. The problem is, you need cash ASAP to buy new production equipment. So you factor the Stark’s industries invoice. The factoring company gives you a good portion of that $200,000 up front (typically 70 to 90 percent) of your total upcoming invoice, minus a few percent to cover their rates.

So Stark Industries has an invoice of $200,000. So if the factoring firm is willing to advance 90% of the invoice, then Stark Industries will get $180,000 upfront, less the invoice factoring fees. The remaining invoice amount ($20,000) will be held in reserve and will be paid out once your clients have paid their invoices.

Difference between Invoice Factoring and a Loan

The main difference between factoring and a traditional loan is who owns the invoices. Factoring firms actually buy your invoices at a discount rate.On the other hand, banks use the invoices as collateral on the loan in the event of nonpayment (by your company).

Because of this shift in responsibility, you are no longer responsible for the invoice for obtaining payment for the invoices you sold. Instead, the factoring firm is now responsible for obtaining payment.

In dealing with invoice factoring, it is essential to understand that it is very different from borrowing in an organization’s sell accounts receivables rather than merely serving as collateral. The immediate result is that your organization can immediately convert the receivables into instant operating cash. This saves the time of having to wait for over 60 days or more for clients to pay.

Invoice factoring is ideal for businesses that need funds fast but cannot obtain a traditional loan from banks. A lot of people refer to this practice by various terms, such as debtor funding, receivables factoring, invoice factoring, and invoice discounting.

Good factoring firms can review the credit history of the seller’s buyers before buying invoices. Factors would like to be sure that these businesses have a tradition of covering their bills. The factor would also allow for non-recourse factoring. Non-recourse covers the business if your firm is insolvent during the transaction time.

How Much Does Invoice Factoring Cost?

Costs depend on the factoring firm, invoice size and volume, and the type of business. 

But a factoring firm would typically bill a flat percentage (say 2 percent) for the first 30-90 days and a certain percent (say 0.5 percent) for the amount of days the invoice remains outstanding. Fees are also alluded to as invoice discount rates. Most factoring firms offer a flat rate arrangement where a one-time fee is paid in advance.

Because the fees are added on every additional day that the invoice isn’t paid after the 30 days, it is extremely important that clients you are invoicing have great payment history. Because if the invoice is paid late, you will incur excess charges.

Advantages and Disadvantages of Invoice Factoring

Like anything, there are drawbacks and advantages to this method of financing. Below, we quickly summarize the pros and cons of invoice factoring.

Pros of Invoice Factoring

  • You get immediate instant cash flow as a business
  • There is an ongoing cash flow
  • The chances of getting approved for invoice factoring is high if you are an established business with large invoices
  • There is no involvement of collateral.
  • Improved customer relationship
  • Ability to outsource

Cons of Invoice Factoring

  • Fees on unpaid invoices
  • Sometimes it can be expensive to start
  • Lack of control

What Businesses Benefit From Invoice Factoring?

As previously stated, invoice factoring is ideal for businesses that need constant cash flow but do not want to go (or can’t go) through the traditional loan process. However, that is not the only factor in assessing your need for invoice factoring. In addition to businesses needing cash flow, the following types of businesses can benefit from invoice factoring:

  1. Businesses needing to meet a sudden surge in demand (ex: companies supplying gloves during 2020)
  2. Businesses that are established and have great credit
  3. Businesses that get invoices paid on time, all the time (publishers that are paid by advertisers)
  4. Businesses that have a few large invoices rather than many small invoices (higher customer concentration rate)
  5. Businesses that get paid by big and established businesses
  6. Businesses with low customer turnover

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