What Is Invoice Factoring and How Does It Work?
Every business has to focus on its liquidity. Having a constant cash flow you can invest back into your business is one of the major elements affecting its growth.
However, getting your B2B customers to pay the invoices you issued sooner than they are required to isn’t always easy. Is there an alternative to just praying they’ll pay you before the date specified on the invoice? After all, you have due dates on important bills coming up.
Yes, you can sell those invoices for cash.
What Is Invoice Factoring?
This term refers to you selling your business’ uncollected invoices still covered by the payment term to a third party. It can be especially of use to small companies that need a predictable cash flow, and every product and service paid as soon as possible to grow further.
Even though the 30-day payment term is the most common on invoices, you might not have enough liquidity to cover your expenses in the meantime. Selling these invoices instead of taking a loan or looking for another source of funds might be a smart move for your business.
The third party that provides invoice factoring services is a company that’ll buy your invoices at a discount. The process is very quick, as the company will likely pay you out the majority of your sold invoices within a day or two. Unlike loans, this solution also has a higher and quicker approval rate. The company buying your uncollected invoices won’t look into your company’s history - instead, it'll take your client’s creditworthiness into consideration.
Also known as accounts receivable or debt factoring, this quick cash solution gives your business much-needed liquidity. It provides cash to handle pressing expenses without having to inconvenience your B2B clients by asking them to pay before the term mandates them to do so.
How Does Invoice Factoring Work?
Let’s say you delivered your service, and now your client owes you $10,000. You were comfortable with them paying it within 30 days, but, due to some unexpected expenses, you don’t have enough ready money to pay your workers’ wages, which are due in two days. However, the due date on your invoice is still a month away, and the company you’ve provided services or sold goods to isn’t required to pay it before the date.
One of your options is to look for the best factoring companies that offer the most favorable invoice factoring rates.
Here’s how it works. For example, a company promises 90% of your invoice amount upfront (the advance rate). It purchases the invoice at a 1% discount and will be repaid by the payment term your client had agreed to when you issued the invoice.
The very next day, the factoring company pays you $9,000, which you use to pay your workers immediately. When your client pays the invoice factoring company the full $10,000 invoice by the end of the term specified on the invoice, the factoring company keeps the 1% discount and pays you back the remaining $900.
While this is how it works in very broad strokes, it’s usually not so easy in practice, so you should always read the fine print. It can be an excellent solution when you are in a pinch. Still, there are disadvantages that can make you consider taking a business line of credit instead.
Invoice Factoring Costs
There are many variables involved with selling your invoices receivable. Here’s a quick overview of the most common fees involved.
Application or Due Diligence Fees
Factoring companies perform due diligence before accepting or declining to buy your invoices. Some charge application or due diligence fees separately.
Advanced Discount Fee
The advanced discount fee covers the cost of paying you your invoices upfront. It can be anywhere from 1% to 5%, and it typically covers up to 45 days.
Invoice Factoring Fee
If your customer doesn’t pay within the agreed timeframe, the factoring company will likely charge you for the wait. The cost will typically range from 2% to 3% for each month the payment is still receivable.
Some companies will try to persuade you to sign a long-term contract. This could be beneficial for large companies that issue many invoices or have longer payment terms. Still, most small businesses will only struggle with this, as there is a monthly target to be met to avoid a monthly invoice fee. Plus, in case you decide to break the contract earlier, a closing or cancellation fee will likely apply.
Pros and Cons of Invoice Factoring
Improved cash flow and easier and faster approval are probably the most appealing aspects of factoring in your invoices. While there are some outstanding loans for small businesses and even loans for those with bad credit, getting approved is often time-consuming.
However, there are cons to debt factoring as well. Once you sell the invoice, you sell the control over it, too. Occasionally, the company will accept to buy all outstanding invoices and won’t allow you to select the ones you’d be comfortable selling. In the worst-case scenario - the client may not pay by the agreed date. The invoice factoring companies can charge you late fees (nonrecourse factor) or ask you to repurchase the invoice at a higher cost (recourse factor).
The factoring company might also pursue the payment even before it’s due more aggressively than you would dream of, costing you the client in the long run. Your customers can also perceive it as a sign that your company is struggling financially.
Typically, the initial cost of factoring invoices can be anywhere between 1% and 5%, but additional fees can be hidden in the fine print.
The practice is currently unregulated in the US, but there are some indications this might change in the future.
Invoice discounting is the way to get the money you’re owed by staking your unpaid invoices as collateral for a loan with a third party. You are still in charge of getting those invoices paid, and there is no need to include a third party between you and your customer. What is invoice factoring in comparison? With factoring, it is the factoring company that purchases your invoices outright, and it has complete control over its payment.
I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.
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