What Is Invoice Factoring?
With standard invoicing periods of 30 – 90 days, you probably won’t be paid for at least a month after sending the bill to the customer. Many small business owners face a perpetual cash flow constraint because of these lengthy payment terms, making it difficult to pay for necessities like rent, electricity, and inventory. The inability to do so probably limits you from investing in growth possibilities and from keeping the day-to-day operations that keep everything on track running smoothly.
When you use invoice factoring, you sell your unpaid bills to a third party (the factoring company) in return for immediate cash.
It won’t affect your credit score as a loan would from a bank since it’s a sale and not a loan. To avoid misunderstandings, “factoring” is synonymous with “accounts receivable financing.” Using this method, small businesses may access the cash worth of their invoices months before their customers pay the bills.
How Does Invoice Factoring Work?
Factoring is an alternative to traditional lending for small businesses. A factoring company (or “factor”) is a third party that helps small business owners get paid by “factoring” their invoices rather than going via traditional lending institutions like banks. If your company issues invoices with net terms of 30 to 90 days, invoice factoring may be the financial solution for you. Invoice factoring is a way for companies to swiftly get access to additional financing by selling their outstanding invoices.
Factors “purchase” your company’s invoices rather than providing a lump sum loan like a bank would. To “factor” an invoice is to sell it to a factoring company in exchange for a percentage of the invoice’s total value, which you will get upon the invoice’s payment. You are paid a certain proportion of the total invoice amount, while the factoring business keeps the remainder as their fee for facilitating the payment and collection process. The factor will then pursue payment on the invoices you sold them. Since the factor is taking on risk by factoring your invoices, they will only advance a percentage of the invoice value to you up front.
After this invoice “sale” is finalized, the factor has legal ownership of the invoice and is responsible for collecting payment from the buyer. The customer owing the money on the invoice will be contacted by the factoring provider, and they will deal with any payments or inquiries directly with the factor rather than with you. You should think about this aspect of invoice factoring since it will unavoidably damage your relationship with the client.
Invoice Factoring vs. Invoice Financing
There is a key distinction between invoice factoring and invoice financing, and that is who will be responsible for collecting on your invoices. The collection process remains under your supervision when you use invoice financing. However, with invoice factoring, the factoring business takes on the responsibility of collecting on the invoices they buy. Both types of funding are equivalent with the exception of the method of collection (i.e. assignment).
Invoice Factoring vs. Invoice Discounting
Invoicing customers is a common practice for every business that has successfully delivered on a service or product. Businesses may get the money they need to pay things like rent, electricity, and employee wages by sending a copy of their invoice to a lender.
Invoice discounting is especially helpful for small businesses since it ensures a steady flow of cash all month long, even if the invoice isn’t paid until the end of the month. Waiting till the end of the month for a lump sum payment isn’t always a feasible choice, thus this is a good alternative.
Lending amounts often range from 80% to 90% of the invoice value at several invoice discounting services. You proceed with regular customer collections after receiving the up-front loan.
Lenders normally have extremely open and comprehensible charge structures (about 1% to 3%). However, circumstances may call for different solutions. Therefore, it is essential for small businesses to properly budget their resources.
What’s Involved In A Factoring Transaction?
- After providing a service or making a delivery, the Seller invoices the Debtor.
- The Seller sends the Factoring Company that invoice for financing (for example, on Day 1)
- The factoring company deposits 80 – 90% of the invoice amount into the seller’s business bank account as an advance to them (for example, on Day 2)
- The Factoring Company receives the money by mail from the Debtor, who deposits it in a lockbox under the Seller’s name (for example, on Day 25)
- A minor factoring charge is deducted before the remaining 10 – 20% of the invoice value is released to the seller (for example, on Day 26)
Factoring Advantages And Disadvantages
Factoring allows you to immediately put money you’ve already earned to work in your company. There is no longer any need to wait 4, 8, or even 12 weeks to get paid. With the money you get through factoring, you may pay your employees, buy new supplies and equipment, take on bigger contracts, and expand your firm anyway you see fit. It frees up your time by allowing you to choose when you are paid for your invoices.
How Do Companies Qualify For Invoice Factoring?
In order to qualify for factoring, your company will need to have the following items:
- Invoices to factor
- Creditworthy clients
- A completed factoring application – Apply Now
- An accounts receivable aging report
- A business bank account
- A tax ID number
- A form of personal identification