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Understanding Invoice Factoring and How to Use it.
Invoice factoring is a financing solution that allows small business owners to turn unpaid invoices into cash for short-term working capital.
Small business owners in need of immediate cash infusions may wish to consider invoice factoring as a financing option. This method of business financing is best suited for companies that do business with other companies since invoicing is typically done with 30 days payment terms.
How Does Invoice Factoring Work?
Invoice factoring is not a business loan. It’s is a financing arrangement for small businesses that involves selling unpaid invoices or outstanding invoices (or in some cases their accounts receivables) to a third party (invoice factoring company) in exchange for a lump sum of cash. Technically, invoice factoring is not considered a loan because the business owner is not required to make any payments after they sell their invoices.
Let’s say that you have 100 invoices that are active and due in 30 days. For hypothetical purposes we’ll assume that each invoice is for $1,000. That means your business has $100,000 in unpaid invoices or what is referred to as invoice value.
You need immediate cash so you contact an invoice factoring company and they agree to purchase your unpaid invoices. The factoring company charges a “factoring fee” of 5% of the value of your invoices so they charge $5,000 and agree to buy the invoices for $95,000 ($100,000 minus $5,000 factor fee). Typically, the factoring company will make an upfront payment of the invoice value less a holdback amount in case invoice amounts are not paid by customers. Invoice factoring companies may wish to pay 80% of the invoice value less the factoring fee. In this case 80% of $95,000 would be the amount of the advance paid upfront or $76,000 ($95,000 x 80% = $76,000); with the remainder of $19,000 paid to the small business after the invoices have been paid in full.
What You Need to Know About Invoice Factoring Details
Invoice factoring involves a few technical terms that you will want to become familiar with as well as a few terms that are different ways of saying the same thing. Like any type of financing, you want to understand your obligations and options. Reading and understanding your invoice factoring agreement is critical.
Invoice Factoring Pros
Using this type of financing is very different than traditional bank loans, business lines of credit, cash advances or small business loans. First, invoice factoring is not a loan. The good news is that you won’t be asked to submit a credit score or credit checks or use your personal credit in most cases. This is a sale of an asset so it’s not based on your creditworthiness. Unlike loans you also won’t have to worry about late payments.
Simple approval process: Invoice factoring eligibility does not require excellent credit, a long time in business or collateral. Invoice factoring providers focus on your total invoice amounts and types of invoices they are purchasing.
No collateral requirements: Typically, invoice factoring is considered unsecured funding so there is no risk of losing assets if there is a default.
Immediate cash flow: Selling your future invoice payments will boost cash flow immediately.
Invoice Factoring Cons
So far we have focused on the positive aspects of invoice factoring. However, there are some downsides and risks associated with this type of financing.
Loss of Control: Since you transfer ownership of the invoices to an invoice factoring service, you also give-up the right to collect from your own customers. It is important to understand the collection practices of your provider to ensure it is done in a friendly and ethical manner. Keep in mind that you are still doing business with your customers. If your provider uses heavy-handed collection methods, you may risk losing your client.
Customer creditworthiness or questionable finances may disqualify some invoices: While your invoice factoring service may not check your credit, they will likely research your customer’s business credit. Your provider will want to ensure that they can get paid on their invoices, so some of those invoices may not be accepted by the factoring company if they feel your customer has weak finances. This could also take some time to research and delay or reduce your payment.
Invoice factoring cost: Invoice factoring is regarded as a high cost financing option. In addition to factoring fees, your factoring agreement may include service fees, fees on late customer payments, credit check fees and any other additional fees in your factoring agreement. It is important to understand and seek-out any hidden fees imposed by the finance company.
Not suitable for all types of business: Invoice factoring is best suited for companies that engage in business-to-business commerce. Factoring companies generally do not work with business to consumer invoicing.
Some Terms Associated With Invoice Factoring
Invoice factoring company: A company that specializes in purchasing outstanding invoices from businesses. Also known as an invoice factoring services.
Factor rate: Is the rate of invoice discounting that determines the factor fee.
factoring fee: Is the percentage (factoring rate) of invoice value your factoring company charges to purchase your outstanding invoices (in addition to any other fees). Factoring fees can range from 1%-5% depending on the volume of invoices, business type and the creditworthiness of your customers. This fee will also be affected by whether the factor is ‘recourse” or “non-recourse.”
Recourse factoring: In the event one or several clients do not pay their invoice amounts, the factoring company has the right to collect from the business that sold the invoices.
Non-recourse factoring: In the event that clients do not pay their outstanding invoices, the factoring company cannot collect from the company that sold the invoices.
Invoice value: The total dollar amount assigned to all invoices sold to the factoring company.
Advance rate: The amount of the upfront cash payment the factoring company advances to the business. This rate is expressed as a percentage of the invoice value (minus fees).
Invoice factor agreement: Is the legal contract governing the terms of the invoice factoring financing.
Service fee: Fees associated with collection activities and bookkeeping and are typically assessed for each invoice.
Invoice due: This term is used to describe an invoice that is due immediately.
Invoice financing: Is a financing option where a business uses accounts receivable as collateral against a loan.
Is there a difference between invoice factoring and invoice financing?
Yes, there are major differences between the two.
With invoice financing a business will pledge accounts receivable to a lender as collateral for a loan. In this case the borrower also retains ownership of there invoices and maintains direct collection responsibility with its clients.
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