A Complete Guide to Invoice Factoring for Small Businesses

As a small business owner, you may run out of funds when your expenses are high. For example, you might assume that your customers will pay their invoices on time and that you can use those funds to cover your expenses. However, if your customers pay late, you’ll find yourself short on cash. Bringing in funds on time can be difficult, especially when you’re just starting out. Perhaps that’s why you need to use invoicing!

What is invoice factoring?

Invoice factoring is a type of invoice financing where you “sell” some or all of your company’s outstanding invoices to a third party in order to improve your cash flow and income stability. The billing company will pay you most of the billed amount immediately, and then collect payment directly from your customers. There are advantages and disadvantages to invoice factoring, which we will cover in this article.

How does invoice factoring work?

Invoice factoring means selling control of your accounts, either in whole or in part. It works like this:

1. You provide goods or services to your customers in the normal way.
2. You invoice your customers for those goods or services.
3. You “sell” the raised invoices to the factoring company. After the factoring company verifies that the invoices are valid, they pay you the bulk of the invoiced amount immediately, usually up to 80-90% of the value.
4. Your customers pay the factoring company directly. The factoring company follows up on invoice payment if necessary.
5. The factoring company pays you the remaining invoice amount – minus their fee – after you have paid them in full.

Let’s look at the example of John, a small business owner. A few months ago, he issued an invoice for $30,000 with a 10-day payment period. His client paid the full amount, but not until 3 days before the due date. While he was waiting for the customer to pay, he noticed that one of his suppliers was offering a discount if he bought raw materials in bulk.

However, the offer was only valid for a limited time. He lost the discount because he didn’t have enough funds. Waiting for his customer to complete the bill payment affected his expenses and cash flow. To improve cash flow, he decided to try invoice factoring.

And now he issues a similar invoice for $10,000, but instead of waiting for the customer to pay, he uses invoice factoring. He earns $8,000 (80% of the invoice amount). Then, the customer pays the invoice amount within 90 days. The factoring company incurs a service fee of 30% or $4 and gives John the balance. So John receives a total of $4,000. Although he did not receive the full amount of the invoice, he was able to move forward immediately. His cash flow was good, and he didn’t have to wait.

The invoice factoring process begins right when you invoice your customer for the goods or services they have purchased. You then contact your chosen factoring firm and go through their application process (if you haven’t already) to sell them your outstanding invoices. After clearing the screening process, the factoring firm will sign an agreement and determine the initial amount you can borrow upfront.

Within 1-4 business days, the factoring firm will pay you the advance, which is usually around 75-90% of the invoice amount. The amount upfront is based on risk factors, your industry, and the size of the deal. After your advance is paid, the factoring firm will send your customers an invoice agreement notification.

When your customer pays the invoice amount, the factoring firm will reduce their invoice amount and transfer the balance to you. A factor fee, also known as a discount rate, essentially represents the cost of borrowing money from a factoring firm. Payment is usually made weekly or monthly, and if the customer takes a long time to pay the invoice amount, the factor fee will be larger, typically ranging from 1% to 5% depending on the industry.

Before getting involved in invoice factoring, check who is involved and what they do.

Eligibility criteria for invoice factoring

Invoice factoring works best for B2B and B2G firms that offer payment terms of 30-90 days. The paperwork required to enter an invoice factoring agreement varies from firm to firm. Typically, a business owner must provide financial documentation such as accounts receivable aging statements, sales reports, a detailed list of customers, and relevant outstanding invoices. Some firms have also recently started asking for tax returns for accuracy.

To qualify for invoice factoring, a business owner must:

• Meet established thresholds for annual revenue and profit margin (varies for different firms).
• Have good customers with a good credit history. Factoring firms are likely to be more beneficial if you have customers who pay on time.
• Not rely solely on purchase orders and proposed invoices, as factoring firms do not accept them as collateral.
• Have a clean background with no tax records and no history of bankruptcy.

Advantages of invoice factoring

• Improved and more progressive cash flow: By utilizing invoice factoring, you can pay the majority of your invoices almost immediately (potentially after extensive follow-up on your behalf) rather than waiting for the money to arrive. This makes business planning and forecasting more accurate and allows you to take advantage of otherwise inexpensive opportunities.
• Better chance for your business to survive: Improved cash flow gives your business a better chance to survive. With many businesses failing due to poor cash flow, invoice factoring can keep you healthy—as long as you use it wisely.
• Cheaper and easier than a bank loan: Invoice factoring is usually more cost-effective and easier to obtain than a bank loan, which is useful for short-term financing needs. It also eliminates the hassle of debt management. Depending on the size of your customer base, this can result in significant savings.
• Reduced business overhead: Invoice factoring services can decrease your business overhead. Although there are costs associated with invoice factoring, they may be lower than the expenses of paying specialized credit control staff. Invoice factoring can also improve the morale of individuals in the accounts department since chasing up payments is often a stressful job.

Disadvantages of invoice factoring

• Unsuitable for businesses with few customers: Invoice factoring is not suitable for companies with only a few key customers. Factoring companies prefer to spread their risk as widely as possible and avoid high concentration on just a few customers.
• Requires a significant commitment: While it is sometimes possible to factor a small number of invoices (known as selective factoring or spot factoring), most factoring companies will prefer to handle the majority of your accounts. They may also require you to sign a long-term contract, which could be two years or more. This is necessary from their perspective, but it means you can’t easily enter and exit invoice factoring at any time. It’s a major business decision.
• Increased costs if your customers are risky: Factoring companies do their best to assess the risk of late payment or default. This means that they will carefully evaluate your customers, and their charges will reflect their perception of credit risk. If you or your customers are considered high risk, the fees will be higher.
• Additional costs if it doesn’t work out: If your customers turn out to be worse payers than expected, there may be additional funds to pay. If the customer does not pay, you may have to refund the amount that the factoring firm has already paid you unless you charge extra for non-recourse factoring. In short, don’t expect a factoring company to take over your bad debts for nothing. They are in business to make money, just like you.
• Potential damage to customer relationships: When invoice factoring and credit control are handled by a factoring company, you are also relinquishing some control over your customer relationships. If the factoring company handles the debt coldly or aggressively, you run the risk of your customers ceasing to do business with you in the future. They may also perceive the involvement of a factoring company as an indication that your business is not performing well.

Conclusion

In general, invoice factoring is a useful way to obtain cash on time. It is easy to set up and enables quick payment. However, before diving into invoice factoring, it is advisable to consider the pros and cons. This option can be expensive if your customers consistently make late payments. Therefore, ensure that it is suitable for your business before initiating the process.