What You Need to Know About Invoice Factoring
If you are experiencing delayed payments, you may lack adequate cash to finance your payroll, bills, investment, and expand to a new location. For you to overcome this constraint, the solution is to pursue the option of invoice factoring. It is vital to note that the majority of entrepreneurs are currently using invoice factoring as an option of getting fast cash against their unpaid invoices.
Customer payments that are slow or delayed are one of the most challenging circumstances a small business owner can encounter. Sometimes, entrepreneurs have to wait up to 90 days before their invoices are paid. For sure, slow-paying customers can adversely affect your business operations.
What is Invoice Factoring?
Invoice factoring is an arrangement whereby a business entity sells its account receivables at a discount to a factoring company. Therefore, the factoring company takes up the responsibility of collecting the account receivables while the entrepreneur goes on with their business.
With this option, factoring companies can advance you 70-90% of the invoice value beforehand. Note that the remaining balance, less a fee, is remitted to you after the final collection is done on the invoice.
Before a factoring company grants you money, it has to check the creditworthiness of your customers. If satisfied with their credit history, the company can go ahead and fund you up to 90% of the receivable value for your business requirements.
Whereas banks are interested in your creditworthiness, factoring companies are only concerned with the credit history of your customers. Therefore, in case you have a terrible experience with banks due to your past payment, you can use invoice factoring as an option to get short term financing.
Invoice factoring is a way of getting immediate cash from unpaid invoices. This option is ideal for ant business experiencing delayed payments from its customers. Invoice factoring can be offered by any financial institution, such as banks.
How Invoice Factoring Works
With invoice factoring, you don’t have to wait until your clients pay to finance essential operations like salary payment and purchase of new equipment. Through invoice factoring companies, you can get immediate cash, within 24-48 hours, and go on with your business operation.
The following is a highlight of the steps indicating how invoice factoring works.
• Issuing of invoices to customers
After you have delivered products or services to your customers, the next thing to do is to issue invoices with net terms to them.
• Identification of the appropriate factoring company
It is crucial to select the right factoring company to work with. Before you make any choice, it is essential to consider its track records and service fees. Once you identify a particular factor, you then issue them with your invoice details and agree to payments.
• Advance payment of invoice value
Once you agree with the factoring company, you are then paid upfront between70-90% of the invoice amount. With this cash, you can pay salaries, buy inventories, and pay suppliers.
• Collection of invoices (account receivables)
After making a certain proportion of payment to you, a factoring company undertakes to collect the invoices from your customers as per the agreed terms.
• Final submission of the invoice balance
After a successful collection, the factoring company remits the rest of the invoice value to you less a service fee.
It is crucial to note that with invoice factoring, all the three parties benefit. For instance, the factoring company gets a service fee, the business entity gets advance payment, and the customers get favorable terms of payment.
Different Types of Invoice Factoring Costs You Need to Know
There are many companies offering invoice factoring services, and, therefore, it is crucial to check their quotes to select the most affordable. Below is a description of the various factoring charges.
• Application fee
A quite number of factors charge an application fee to cater for the due diligence service they offer as a result of conducting preliminary investigations on the creditworthiness of your customers. The application fees vary from one company to another; therefore, you should compare many factors before you settle for the cheapest one.
• Closing fee
A closing fee is a small proportion retained from the value of each invoice by the factoring company after giving you the service. Also, note that the magnitude of this fee varies from one company to another.
• Termination fees
Sometimes, factoring companies may require that you sign a long-term contract of selling a specific amount of invoice to them. Therefore, in case you terminate the contract early, you will incur a termination fee.
• Discount fee
A discount fee is a cost of paying for your invoice beforehand. The value for this cost ranges between 1.5-5% of the invoice value per month. The discount fee varies across factors, and you should always check their quotes before you engage any company for the service.
• Invoice factoring fee
The invoice factoring fee is charged based on the number of days the account receivables are outstanding. Usually, the advance discount fee covers 30 days. However, if your receivables are outstanding beyond the standard time, the factor will charge you invoice factoring fee of 2-3% depending on the number of days the invoices are past due.
Advantages of Invoice Factoring
Invoice factoring is an essential source of funds for your business. The following is a highlight of the benefits associated with this option.
• Immediate cash
With invoice factoring, you can get advance payment before your invoices are paid. By getting quick money, it implies that your business activities will go on uninterrupted.
• Fast approval
Unlike traditional loans, an application for invoice factoring can be quickly approved because factoring companies only consider the creditworthiness of your customers.
• Easier qualification
The qualification to get funded is based on the creditworthiness of your customers. Also, no collateral is required for you to be funded.
• Improved cash flow
Invoice factoring can enhance your cash flow while allowing your trustworthy clients to enjoy long-term payment.
Disadvantages of Invoice Factoring
Although invoice factoring is one of the best options for getting finance, it has its downsides, as explained below.
• Lack of direct control
It is vital to note that invoice factoring companies collect on the invoices from your customers directly without your intervention. Therefore, you may not be aware of whether they deal with your clients professionally or they are mishandling them.
• High cost
Invoice factoring can be expensive because of many charges associated with it, such as application fees, termination fee, and discount charges. Some factoring companies charge costs that are not worth the trade-off for the immediate cash you get.
• The customers’ bad credit records can adversely affect your financing
If the creditworthiness of your customers is terrible, the factoring company may not approve your payments.
• There is no guarantee of collecting the receivables
There is no certainty that the factor will gather on the unpaid invoices. Therefore, if your customers fail to pay, the factoring company will hold you liable for the debt.
The difference between invoice factoring and invoice financing
The primary distinction between invoice factoring and invoice financing revolves around who collects the invoices among others. The following explanations will bring out the differences between the two options.
• Invoice factoring
With invoice factoring, a factor buys your invoices for a certain proportion of their value and collects the outstanding payments from your customers. The amount paid to you in advance is between 70-90% of the invoice value.
• Invoice financing
However, with invoice financing, you are the one who collects the invoices, and you deal directly with your customers. Note that you are supposed to pay back the advance you get with interest and a fee. It is vital to note that with this option, you can use your invoices as collateral to qualify for a loan.
Also, bear in mind that the amount of credit you get is based on the strength of your account receivables, and most invoice finance providers can offer you up to 95% of the invoice amount.
Invoice financing is a better option if you want to exercise control over your invoices and handle your customers directly. However, factoring can also work better if you are going to surrender the supervision of your invoices, and if you feel that the factor can exercise professionalism when dealing with your clients.
What to Consider When Choosing the Best Factoring Company
Getting the best factor to work with can be a challenging task if you don’t know how to go about it. The following is a highlight of factors to look into before selecting a factoring company.
• The type of factoring services offered by the factor
Before you select the company, you must evaluate the nature of the service you need for your firm. It is vital to bear in mind that each factoring company specializes in a particular niche, and, therefore, select the appropriate one based on the service you want.
• The terms of the factoring company
The fee rates charged by different factors are either flat or variable. It is vital to note that you are likely to pay a lower price if you factor a lot of invoices.
The variable fee structures mean that the factoring company will discount a small proportion of the receivables provided that they are still due. Therefore, if your invoices remain unpaid for long, you will pay a higher cost.
However, the rate of the variable fee depends on the account risk, and it may be appropriate to you if you have an excellent business profile.
However, with the flat rate structure, the rate remains constant irrespective of how long the invoice is outstanding. Although flat rate fees are higher than the variable fees structures, they are straightforward to calculate and more cost effective to use. To compute them, you just multiply the value of receivables with the flat fee.
• The industry of the factor
Before you select the company to work with, consider their favorite sector. For instance, some companies may be confined to transport, consulting, and commercial services. However, other factoring firms may be dealing with manufacturing, construction, and distribution. Therefore, it is vital to choose a factor based on your customer’s industry.
• Factoring costs and fees
It is crucial to note that some factoring companies may have hidden fees. Therefore, research thoroughly before selecting the right factor to work with.
• Scrutinize the factoring agreement
Before you sign any contract, read and understand its terms to avoid facing adverse consequences in the future. Also, go through their rates and comprehend the terminologies used.
• The factor’s advance rate
The advance rate is the proportion of invoice value that you will be paid beforehand. The commonly used scale is 70-90% of the receivable/invoice value. Since you need maximum funding based on your invoice value, it is essential to select a factor with the highest advance rate.
• The ease of approval
Before you select any factor, consider how long they take to approve and disburse funds. Some companies can take more than a month to get you cash, while others can take less than ten days to pay money into your account. The difference lies in the level of the factor’s technological adoption.
• The nature of the factor’s customer service
Sometimes, it is hard to tell the factor’s quality of customer service unless you carry out due diligence on them. To make work more comfortable, you can consult a financial advisor to get valuable information regarding the characteristics of the company just before you make any decision.
Conclusion on Invoice Factoring
Invoice factoring is a financial option that can be used by entrepreneurs to get financed based on the strength of their invoices. With this method, you are given an advance payment of 70-90% of the value of your invoice.
With invoice factoring, you pass the responsibility of collecting your invoices to a factor while you concentrate on running your business affairs. Before you select a factoring company to deal with, it is vital to consider its costs, nature of service, advance rate, and the ease of their fund approval.