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Invoice factoring turns unpaid invoices into fast cash to help finance short-term needs for your small business. As a small business owner, you can turn your unpaid customer invoices into fast cash with invoice factoring. This financing option is best for business owners whose customers are other businesses. Because these customers typically don't pay for goods or services right away, invoice factoring can provide immediate cash for business owners to keep paying employees or other expenses.
Invoice factoring is a way for businesses to fund cash flow by selling their invoices to a third party (a factor, or factoring company) at a discount. Invoice factoring can be provided by independent finance providers, or by banks.
Technically, invoice factoring is not a loan. Rather, you sell your invoices at a discount to a factoring company in exchange for a lump sum of cash. The factoring company then owns the invoices and gets paid when it collects from your customers, typically in 30 to 90 days.
Let's say you own a hardware store and sell goods to another business, creating a $10,000 invoice. Your customer agrees to pay off its invoice in 30 days, but you need the cash next week to pay your employees. You've got a cash shortfall.
You could turn to a traditional bank for a loan, but it likely would require stellar personal credit plus collateral, a physical asset such as real estate that the lender could sell if you default. Or maybe you qualify but can't wait several months for the loan to close.
So you turn to an invoice factoring company, and it agrees to buy your invoice for $9,700 in cash — $10,000 minus a 3% factoring fee ($300). The invoice factoring company advances 85% of the invoice (or $8,245) within a few days. The factoring company then collects the invoice when it's due and provides the remaining balance owed to you ($1,455).
The factoring fee, also known as the discount rate, can run from 1% to 5%, depending on the invoice amount, your sales volume, your customer's creditworthiness and whether the factor is "recourse" or "nonrecourse." The factor type refers to who is ultimately responsible for an invoice that goes unpaid — your company or the factoring company.
If the contract is a recourse factor and the customer doesn't pay, you may have to buy back the unpaid receivable from the factoring company or replace it with a more current receivable of equal or greater value. If it's a nonrecourse factor, you're under no obligation to repay or replace the unpaid receivables, but you'll likely be charged a higher transaction fee because the factoring company takes on the added risk of not getting its money back.
Invoice factoring is also known as Debt factoring, Invoice Finance, and/ or Asset based Lending. It's very common to be confused with Invoice Financing which I'll breakdown further down this page.
Although it can be frustrating to wait for customers to pay off their remaining balances, qualifying for invoice factoring can help you navigate this challenge. Invoice factoring loans can be a great option for business owners that need financing while they wait for customer payments.
Invoice factoring works well for business owners that require fast funding, have reliable customers that pay their invoices on time, and can afford the fees that come with selling invoices to a third party. If this sounds like your business, you might benefit from an invoice factoring solution!
As previously mentioned, the biggest benefit of invoice factoring is that you can receive the money owed to your business without having to wait for customers to pay you back. Other benefits or advantages to invoice factoring include:
When applying for a bank loan, it can take months to be approved. Then, it can take additional time to actually receive the financing once you receive your approval status.
In comparison, invoice factoring gives you access to cash quickly (in some cases, you can get same day funding), so you can keep your business running smoothly. This is an especially viable option if your business is in the following situations:
Invoice factoring doesn't need to be a one-time financing option. You can build a relationship with your factoring company that will continue if it makes sense for your business. Maintaining cash flow won't be a problem because you won't have to wait for invoices to be paid before you have money in your bank account each month.
Collateral, credit score, and loan history aren't major factors in determining your ability to use invoice factoring. Typically, the factoring company will be most concerned with looking at the payment history of your customers because this indicates what kind of risk they're taking on.
Therefore, if your credit score is low or your financial history includes other red flags, invoice factoring still might be a feasible option.
Keeping track of outstanding invoices and contacting customers is time consuming. Due to this, delegating those tasks to another company will take a major task off your plate. You'll have more time during the business day to deal with other responsibilities, while the factoring company sets terms and contacts customers for payment.
Invoice factoring is unsecured financing, which means it doesn't require collateral. The invoices themselves act as collateral, so you don't have to worry about submitting real estate, equipment or other larger forms of collateral.
The fees associated with this type of financing can be limiting. Typically, a factoring company will charge between 1 and 5 percent of the total invoice amount in service fees. Due to this, you'll need to decide if the tradeoff for immediate cash is worth the loss.
If your business is on a tight budget, it might make sense to wait for customer payments instead of receiving invoice factoring at an additional cost.
It's important to know that you may be responsible for unpaid invoices. Invoice factoring companies don't act as collections agencies, and they most likely won't take extra time to track down late paying customers.
If you have a recourse invoice factoring agreement, you'll be responsible for paying for those unpaid invoices, or trading in a different invoice of the same amount to cover the cost.
When determining eligibility for invoice factoring, the factoring company will look at your customers' payment history to calculate the risk of taking on your invoices.
If your customers have a habit of not paying you on time, the factoring company will assume they won't be paid on time either. Due to this, they'll be less likely to take on your invoices, because it may be too much risk.
Invoice factoring involves handing over complete control of your invoices to another company. Some business owners don't like this, because they don't want another company having access to their financial information.
Before applying for invoice factoring, you should ensure that you're comfortable with that company and their financial practices. If you choose a reputable factoring company, you should be confident that the process will go smoothly.
Now that you've learned the ins and outs of invoice factoring financing, it's important that you also know about invoice financing, which is a similar option.
With invoice financing, also known as accounts receivable financing, your invoices are purchased by the lender, but you must pay a percentage of the customer's balance.
Then, the invoice financing company will work on collecting the customer's payment. Once they receive it, the remaining amount is factored back to your business. This amount won't include origination fees that were acquired.
Both invoice factoring and invoice financing can be beneficial, but it's important to determine which method makes more sense for your company. If you want more control over collecting your outstanding balances, invoice financing might be the best choice. However, if you want to avoid spending time contacting your customers about their outstanding balances, factoring could be a better option.
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