What is invoice factoring?
Invoice factoring is a type of invoice financing in which you “sell” some or all of your unpaid invoices to a third party to enhance your cash flow and revenue stability.
A factoring business will pay you the majority of the billed amount right away and collect payment from your clients directly. This post will go through the positives and downsides of invoice factoring.
Factoring of invoices is also known as accounts receivable factoring or debt factoring.
How does factoring work?
The practice of selling some or all of your accounts receivable to a third party is invoice factoring. It works like this:
- You supply your consumers with conventional items or services.
- For such items or services, you send an invoice to your consumers.
- The increased invoices are “sold” to a factoring business. After establishing that the invoices are authentic, the factoring business pays you the majority of the billed amount right away, often up to 80-90 percent of the value. If required, the factoring business pursues invoice payment.
- Once they’ve been paid in full, the factoring business gives you the balance of the invoice minus their charge.
When should your company use factoring?
When your firm has a lot of overdue bills, and your cash flow is hurting, you might consider invoice factoring.
Let’s imagine your company sells on a 30-day payment schedule.
The majority of your creditors will pay within 30 days — some will require pursuing, while others will go beyond the limit and necessitate more continuous effort on your behalf. You can’t utilize that 30-day piece of revenue, even if it represents most of your future cash flow.
Invoice factoring allows you to quickly release that money or at least a portion of it. You may use that money towards one of the following:
- Bridge short-term expenses
- Repay a loan
- Take advantage of seasonal business opportunities
- Or for any circumstance where cash flow would typically be a problem
Advantages of factoring
1. Improved and more predictable cash flow –
With invoice factoring, you may get the majority of your invoices paid very immediately rather than having to wait for payment (potentially after extensive chasing on your behalf).
It improves the accuracy of business planning and forecasting, allowing you to take advantage of opportunities that would otherwise be out of reach.
2. Your company has a better chance of surviving –
Better cash flow increases your company’s chances of survival. Many businesses fail due to insufficient cash flow, and invoice factoring may help you keep yours healthy if you utilize it appropriately.
3. It is cheaper and simpler to acquire than a bank loan –
Invoice factoring is typically less expensive and easier to obtain than a bank loan, making it ideal for short-term financial requirements.
It also relieves you of the burden of debt management. That might be a significant saving depending on the size of your consumer base.
Factoring services for bills may help you save money. While invoice factoring has costs, they may be less than hiring professional credit control personnel. Because pursuing payments is a typically tricky job, invoice factoring may enhance the attitude of your accounts department employees.
Disadvantages of factoring
1. Unsuitable for firms with a small number of clients –
Invoice factoring is not appropriate for enterprises with few key customers. Factoring firms seek to distribute their risk over as many people as feasible. They strive to keep the number of bills sent to a few consumers to a minimum.
Although selective factoring (also known as spot factoring) can be used to factor in a small number of invoices, most factoring providers will wish to take over the majority of your accounts receivable. They could also try to lock you into a long-term contract, possibly two years or more.
This is vital from their standpoint, but it means you won’t be able to jump in and out of invoice factoring at will. It is a significant business decision.
2. If your clients are risky, it will cost you more –
Factoring businesses do their utmost to assess the risk of late or non-payment of debt appropriately. This implies they’ll take a close look at your clients.
Costs will reflect their credit risk assessment; if you or your clients are considered high risk, fees will be high.
3. Extra charges if it doesn’t work –
If your clients show out to be worse payers than predicted, you may have to pay more disbursements. Unless you pay extra for non-recourse factoring, you may have to reimburse the money the factoring business has already given you if a customer fails to pay.
In other words, don’t expect a factoring business to pick up your bad loans for free. They, like you, are in business to earn money.
4. Can affect your customer connections –
When you factor bills and the factoring business handles credit management, you’re also handing away some control over your customer relationships.
If the factoring firm pursues the debt cold or pushy, you risk alienating your clients and losing future business. They can see your use of a factoring firm, indicating that your business isn’t performing well.
Also Read: USDA Loan Income Limits
Is invoice factoring a loan?
That’s not the case. Invoice factoring, like a loan, gives you access to funds you don’t have right now, but it’s not officially a loan. An invoicing factoring firm buys a batch of your invoices in return for cash rather than providing you money with the idea that you would repay it.
When they receive payment from your consumers, they’ll get the money back in 30 to 90 days. As previously stated, after your customer pays the invoice factoring agreement, you will get the remaining balance.
When comparing typical bank loans to invoice factoring, there are a few key distinctions to keep in mind:
- Factoring organizations are more concerned with your customer’s creditworthiness than with your own. That’s because it’s your consumers, not you, who is responsible for paying back the loan.
- Invoice factoring is an unsecured kind of finance, which implies that, unlike a bank, it does not need collateral.
- Like any other type of finance, invoice factoring has several advantages and disadvantages.
Let’s take a deeper look at some of the advantages and disadvantages of invoice factoring before making a decision.
Is invoice factoring better than a loan?
It is debatable. Factoring invoices is one of the financial options to explore. Consider your business goals, financial needs, and the value of your outstanding bills when determining if invoice factoring is ideal for you.