With invoice financing, you are pre-selling your unpaid invoices to another company in exchange for a lump sum payout. The accounts receivable financing service will retain a fraction of the value while they wait for your customer to pay. You’ll get the remaining funds owed when the customer has paid, minus the weekly fees that have accrued while waiting for payment. This can become very expensive, so it would be wise to use invoice factoring only with customers that you know will eventually pay.
When the success of your business rests on the timing of payment received from your clients, you might feel like the control is out of your hands. After all, there are only so many invoices and follow-ups you can send, right? If you operate a B2B company, there is a way to put the control of your payments back in your hands. It’s a type of receivables financing known as invoice financing, or invoice factoring. And while it’s a great tool for modern day businesses, factoring actually found its beginnings in ancient Babylon.
Small business factoring provides you with cash advances from a factoring company based on outstanding invoices from your current customers.
Essentially you’re using your unpaid invoices as collateral to receive the funds upfront while you wait for your customer to pay. Keep in mind, however, you won’t receive the full amount of the invoice.
Instead, you usually receive 85% to help cover your costs of business, make other payment obligations, or begin a new venture. The other 15% is held until your customer pays the invoice to the factoring company. Any applicable fees are automatically deducted from that last 15% to pay for the factoring loan. These fees cover the cost of the servicing the loan and can vary depending on which factoring company you work with.
How your invoices are managed and how much you pay for the service also depends largely on the type of service you use…
With invoice financing for a small business (also known as factoring), you sell your invoices and the factoring company actually takes over the management of them.
That means the factoring company is the one contacting your customers and overseeing the payment of the invoice.
Invoice discounting, on the other hand, is more like a cash advance or loan.
You retain ownership of the invoices so that your customers don’t know that you’re using a third party for accounts receivable financing.
Having a factoring minimum means your factor company requires that you use them for at least a certain amount of your invoicing, if not all of it.
They might require that you submit a minimum amount each week or month as part of an ongoing relationship.
Spot factoring, on the other hand, allows you to employ receivable financing only when you need it.
So maybe you have just one large outstanding order that is beginning to put a squeeze on your cash flow.
You simply sign up for factoring services for that one specific invoice.
Just how much invoice factoring costs depends on your exact agreement but the basics are usually the same.
Here’s how these fees play out in a real world example:
Say your invoice is for a major order that totaled $25,000.
Your customer hasn’t paid yet and you need the capital, so you hire a factoring business and receive $21,250 upfront —
About 85% of the total value of the invoice.
Your client pays the invoice three weeks later so you can finally receive the remaining 15%.
Before you do, the factoring company takes out 6%, or $1,500.
That covers the 3% service fee as well as an extra 3% to cover the customer taking three weeks to pay.
In this scenario, out of a $25,000 invoice, you actually bring in $23,500 for the privilege of getting a three week cash advance.
There are several advantages that come with financing receivables through factoring:
As a business owner, you don’t have to put up any type of collateral other than the outstanding invoice.
This keeps your company financials intact because you don’t have to use any other asset base to secure the funds.
Learn more about The Relationship Between Collateral & Small Business Loans
It also makes capital accessible while you wait for your invoices to be paid.
While customers in an ideal world would pay on time every time, it’s just not the reality that many business owners see today.
AR financing gets you the cash you need with minimal hassle.
Learn more about How To Increase Cash Flow When You’ve Hit A Business Plateau
Business factoring also helps you to avoid the full process you’d experience with a traditional bank loan application.
Qualifications are less stringent and you don’t have to go through loan underwriting.
This is because factoring receivables is considered more of a service than a loan.
Consequently, you’ll enjoy a more flexible application process.
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The factoring company can actually help you with collecting your money if that’s an ongoing issue for your business.
Rather than wasting staff time or hiring on new employees to follow-up on late payments, you can redirect your time and money into more lucrative actions.
Factoring companies consider the credit history of the businesses you’ve invoiced in addition to your own.
This puts less of the burden on your company’s financials and more on those you deal with…
But even if you are worried about getting your money back on your invoices, extra help from a factoring service may be worth more expensive fees.
Especially if the alternative is not getting paid at all!
Learn more about How Proper Cash Flow Management Leads to Success
Perhaps the biggest disadvantage of receivable financing is the high fees.
It’s no surprise considering it’s a $3 trillion industry worldwide.
The confusion for many comes in when comparing factoring rates to traditional term loan rates through the annual percentage rate (APR) because this assumes the rate applies to an entire year of repayment.
But a factoring invoice typically only lasts a few weeks.
If you annualize a 3% process fee each month of the year, the APR looks like 36%.
If you compare that to a transaction rate from a credit card, the two are quite similar.
You really need to look at your company’s individual profit margins to assess just how expensive factoring is for you and whether or not it’s worth the service that is provided.
Learn more about How To Calculate APR vs. Interest Rate On A Loan
Another disadvantage of this type of financing is the uncertainty surrounding repayment.
You don’t know exactly when your customer will pay the invoice, which could be why you’re considering a factoring company to begin with.
But since you’re charged a higher fee the longer the invoice goes unpaid, you might find it draining (both financially and emotionally) to not know how much you’ll owe until the very end of the process.
To mitigate your risk, only use factoring for clients who have a long history of repayment.
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Unless you sign up for invoice discounting, your customers will know you’ve outsourced your invoicing to a factoring company.
Depending on your industry and your professional relationships, this may or may not matter to you.
If getting help with collections from wayward customers part of the allure of invoice financing, then you probably don’t care how payments are collected.
But if your business relies on personalized interactions with clients and you are using receivables factoring strictly for the quick cash, you might want to consider how this could affect your future business.
In the event you decide to go with invoice factoring, you should give affected customers a heads up that you’ve outsourced invoice collections in an effort to streamline and make your company more efficient.
After all, that’s what any type of financing comes down to:
A short-term solution to help your business thrive over the long-term.
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It doesn’t take too much to qualify for invoice factoring compared to a bank loan.
The factoring company cares less about your company’s financials and more about the likelihood of the invoice getting paid.
That being said, your business model should meet a few basic qualifications:
In order to use accounts receivable financing, you must be a business-to-business company.
After all, you’re not hiring a collections agency.
Make sure that your profit margins are large enough to cover the factoring fees.
Too small and you could end up losing money on the transaction, which is not a viable long-term financing solution.
A soft credit check may be done to formally verify your creditworthiness.
The real sign of how successful your application will be depends on how many invoices you have and the creditworthiness of your customers.
Some factoring companies have a minimum number of invoices you must provide them while others may like to see a variety of types of customers to mitigate the risk.
Factoring companies also take into account how likely your clients are to pay what they owe.
To determine this, they might look at your customers’ stability, creditworthiness, and/or average payment cycle.
Invoice financing can be an extremely helpful tool to expedite your business cash flow needs.
As long as you’re diligent in your research when selecting a company and read through your contract before signing, your experience should be positive and beneficial to your business.
Once you’ve determined that invoice financing is right for you, there are a number of issues to consider when choosing a service provider…
First take a look around to compare rates and fee structures.
When looking at invoice financing companies, it’s helpful to read online reviews to gauge how other businesses felt about the process.
Full transparency in rates and fees is a must, otherwise you could get stuck for years with a less-than-excellent factoring service.
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Make sure you’re comfortable with the flat processing fee as well as the continued charges as you wait for customers to pay.
Consider the worst-case scenario:
If your client took many months to pay, calculate how much of a profit (if any) you’d make in that situation.
It’s also vital that you read the fine print before signing any contract.
There can be huge penalties upwards of thousands of dollars for ending your contract or stopping automatic renewal.
If you don’t pick a factoring company with reasonable penalties, you might never be able to afford to leave your contract!
In order to expedite the process, you should have certain documents ready before applying.
Here’s what you’ll need to apply for invoice factoring: