As a small-business owner, you’ve undoubtedly considered multiple different means of financing your enterprise. With a few years of success under your belt, you applied for a bank loan — only to be turned down, or offered terms that weren’t even close to being attractive. You’d love to be able to expand, but using credit cards or seeking out investors aren’t really viable options either.
There is another way to gain access to cash that many businesses overlook: Invoice factoring. Also known as accounts receivable financing, invoice factoring allows you to access cash from your outstanding invoices. It’s not a loan, but instead an advance on the funds that your business is owed from outstanding customer invoices. Rather than wait up to 90 days (or longer) to get that money, the factoring company will advance it to you, and then collect payment from the customer directly.
Now, there is a good chance that you’ve heard of this type of financing, but never considered it. Some business owners are under the impression that invoice factoring is only for companies that are in dire financial straits and need instant access to cash to remain solvent. Others fear that their customers will interpret the decision to factor negatively and move to a competitor. The fact is, neither of these concerns are valid. Factoring is actually a sign of a business’s health, and often indicates growth and improvement in products and services. And with proper communication, factoring can not only maintain, but strengthen customer relationships.
How Factoring Works — A Short Guide
Part of the reason that there are so many misconceptions about factoring is that many people don’t understand exactly how it works. To explain that, we’ll start with what factoring isn’t:
- It’s not a loan
- It’s not sending invoices to collection
- It’s not a way to unload “problem” customers
When you work with a factoring company, you are effectively selling your accounts receivable to that company. You’ll receive a portion (usually around 80 percent) of the value of the invoices upfront, and then the remainder of the balance, minus fees, once your customer pays the invoice. Factoring fees vary — they are usually 1 percent to 3 percent of the invoice value — and are determined by the length of time it takes for your customers to pay. You can also expect to pay additional fees to get your account established, which includes performing due diligence on your customers but, in most cases, the fees you’ll pay on factored invoices are considerably less than the interest on a bank loan.
It’s important to note that factoring companies will allow you to pick and choose which invoices to factor, and may not accept all of your invoices based on the creditworthiness of your customers. And should your customers fail to pay, in most cases you will have to purchase their invoices back from the factoring company, and move forward with your own collection efforts. However, because you can usually only factor invoices that are likely to pay on time, the chances of that happening are unlikely.
Benefits to Your Company
You might be asking yourself, “Why would I sell invoices to another company and get less money from customers? Shouldn’t I just wait to get paid and get the full amount?” That’s a valid point, but if you need cash quickly, you may not be able to wait for customers to pay. Not to mention, factoring offers other benefits, including:
- Better Terms than a Bank. Not only is factoring less expensive and faster than a typical bank loan, it also comes without the restrictions that loans do. You can use the money however you want, whether that’s to buy more inventory, expand your space, or just pay off your bills.
- Less Administrative Burden. By selling your accounts receivable, you no longer have to manage that in-house, freeing up staff and time to handle other tasks while reducing operating costs.
- Improved Credit Terms for Customers. When you factor invoices, you can offer increased credit and better terms to customers, since you won’t be on the hook for their outstanding balance for so long. You can get most of the cash for their purchase upfront — and thanks to your factoring companies research into their creditworthiness, be confident in extending that credit.
Factoring isn’t necessarily the best option for all companies, and if you have decent cash flow to manage your expenses and expansion plans already, you may wish to handle your accounts receivables yourself. If you are in the majority of businesses that are always looking for ways to improve liquidity however, factoring may be for you.