Even when running a profitable small business, cash-flow issues arise, especially if you’re customers pay for goods and services over 30-90 days instead of immediately.
One way to solve cash-flow problems is with invoice factoring, where you turn your unpaid invoices into immediate cash. But like every financial product, invoice factoring has it’s pros and cons and may not be a good fit for your small business.
Overview of invoice factoring
Invoice factoring is a financing option for business-to-business (B2B) companies that need help managing cash flow due to slow-paying customers. Factoring enables your business to convert its account receivables — money owed by your customers — into immediate cash.
Invoice factoring is technically not a loan. Rather, you sell your invoices at a discount to an invoice factoring company in exchange for a lump sum of cash. The factoring company then owns the invoices and gets paid when it collects from your customers, which typically occurs within 30 to 90 days.
Let’s say you own a Logistics transportation company, creating thousands of dollars a week worth of accounts receivable invoices. Most of your customers agree to pay off their invoices within 30-45 days, but you need immediate cash to pay employees, buy diesel fuel and other daily expenses, creating a cash-flow shortfall.
You could turn to a traditional banks for a loan, but it requires collateral (a physical asset, such as real estate, which can be sold by the lender if you default) and high personal credit score. Or maybe you qualify but don’t have time to wait several months for the loan to close.
So you turn to an invoice factoring company, and the factor agrees to buy your invoices for $9,700 in cash, less a 3% factoring fee ($300). The invoice factoring company then advances 85% (or $8,245) of the invoice within a few days (although the actual size of the advance will depend on numerous factors, including the total amount of the advance, the age of the invoice and the customer’s creditworthiness). The factoring company then collects the invoice when it’s due and advances the remaining balance owed to you ($1,455).
The factoring fee, also known as a discount rate, can cost anywhere from 1% to 5%, depending on the invoice amount, your sales volume, your customer’s creditworthiness, and if it’s a recourse or non-recourse factor.
If the contract is a recourse factor and the customer doesn’t pay, you may have to buy back the unpaid receivable from the factoring company or replace it with a more current receivable of equal or greater value. If it’s a non-recourse factor, you’re under no obligation to repay or replace the unpaid receivables, but you’ll likely be charged a higher transaction fee because the factoring company takes on the added risk of not getting its money back.
Reasons to use invoice factoring
- Fast cash: Invoice factoring can provide immediate working capital to help cover a funding gap caused by slow-paying customers. You then have the freedom to pay your bills, meet payroll demands, buy equipment and grow your business. Factoring enables you to focus more time on your business and not chasing customers for overdue and/or late payments.
- Easier approval: Invoice factoring provides financing to companies that might not be able to get capital from other sources, such as traditional banks, due to a lack of collateral for a loan, poor personal credit, or a limited operating history. Invoice factoring companies typically only care about the value of the invoices you are looking to factor, as well as the creditworthiness of the customers.
Things to look for when invoice factoring
- Costs: You have to watch out for hidden fees, such as application fees, a processing fee for each invoice you finance, credit check fees or overdue fees if your client is past due on a payment, which can increase your APR.
- Reputation: Because the invoice factoring company collects on the invoices directly from the customer, you need to make sure it’s handled professionally.
- Dependence on customer’s credit: The factoring company may need to verify the creditworthiness of your customer. If the customer has a history of late or missed payments, you may not be approved for the financing.
Alternatives to Invoice Factoring
Invoice financing, also known as discounting or accounts receivables financing, is a bit different than factoring in that you aren’t selling your invoices to a factoring company. Instead, you use the invoices as collateral to obtain a cash advance and you are still responsible for collecting the invoice amounts yourself.
- Improve cash flow: Just like invoice factoring, it allows you to keep loyal customers on longer payment terms. This feature can improve your cash flow and help you grow your business.
- Maintain control: You keep control of your accounts receivables and the collection of payments. This is likely a better option for business owners who prefer to handle collections themselves. Because you control your accounts, it’s likely your customers won’t even know that you’re borrowing funds against the invoices they owe you.
- Credit score not as important: Invoice financing companies care more about your business and the creditworthiness of your customers than your personal credit.
RECEIVABLES-BASED LINE OF CREDIT
A receivables-based line of credit is another invoice financing option for small-businesses. This is a short-term line of credit that is secured by the borrower’s unpaid accounts receivables. It’s structured as a credit line instead of a purchase of your accounts receivables.
Borrowers should understand that a line of credit isn’t like your standard loan, where you get one big cash advance of funds that you need to repay monthly. Instead, it works like a credit card: You get access to a sum of money and you borrow and repay it as you like.
Most credit lines only charge interest on the money you’ve actually borrowed. However, the credit line may come with an end of draw date when you’re no longer able to borrow and you must repay the outstanding balance in full at that time.
- Flexible: A line of credit can provide you with the financial flexibility to manage cash flow and run your small-business. You have access to cash that you can borrow and repay as needed. This can help you better manage cash flow or unexpected expenses.
- Maintain control: You maintain control over the relationship with your customers and will remain responsible for collecting invoices.
- Low cost: Asset-based line of credit costs 10% to 25% APR plus the prime rate (3.5%), making it less expensive than your invoice financing and invoice factoring options.
- Variable rate: Lines of credit usually carry a variable interest rate, which means your payments can rise or fall depending on the prime rate. However, this will depend on each lender, and a fixed-rate option may be available.
- Secured by receivables: Because the receivables are used as collateral for the line of credit, if you can’t repay the line of credit, you will likely have to forfeit these assets, although this will depend on the lender you choose.
Invoice factoring and invoice financing are suited best for established B2B companies that have reliable yet slow-paying customers, which results in a high accounts receivable balance and/or a funding shortfall. These can help immediately to add working capital by utilizing your business accounts receivable assets.
Get the best deal when Invoice Factoring
You can shop your accounts receivable invoices using Factor App. Download Factor App to get the best deal for your invoices. Just like any financial product, it’s important to shop around and compare lenders to get the best deal. At Factor App, Factors compete to buy your invoices, so you get the best deal!