Are you looking for a way to convert your unpaid invoices into fast and easy cash? If so, then you’ll be thrilled to know that there are effective ways to do that. With invoice factoring, you can potentially turn all of your unpaid customer invoices into payment in no time. This payment option works best for small businesses with customers that don’t pay for goods or services right away, yet the business needs immediate cash to run their operations.
To help you better understand this, this invoice factoring guide will discuss everything you’ll need to know about it. You’ll also learn other options on where to find financing.
What is Invoice Factoring?
When people hear the term ‘invoice factoring,’ they’d immediately associate it with getting a loan. However, that’s not quite true. It’s a manner of selling your invoices at a discount to a factoring company. In exchange, the business gets a lump sum of cash. The factoring company will then own the invoices and get paid when it collects from your customers. This process typically takes 30 to 90 days to complete.
How Does Invoice Factoring Work?
To understand invoice factoring, follow these five steps:
- Step 1 – Your business-2-business (B2B) company provides the goods or services to more extensive, credit-worthy customers while submitting the correct invoices.
- Step 2 – Your company needs to be paid sooner than the agreed terms (ex. 30 to 90 days) with your customers.
- Step 3 – Your company sells its unpaid invoices to an invoice factoring company according to the factoring agreement.
- Step 4 – The invoice factoring company will then verify if your invoice(s) are valid with the B2B or Business-2-Government (B2G) company receiving up to 90% of the invoice amount. Once the account is established and set-up, payment can then be made as fast as 24 hours.
- Step 5 – The larger credit-worthy customers will then make payment directly to the factoring company, according to the terms of the invoice. The factoring company will pay the balance (minus ta fee) of the invoice back to the B2B or B2G company.
For instance, let’s say you own a department store that sells goods to another business, creating a $15,000 invoice. Your customer agrees to pay off its invoice in 30 days. However, you need the cash next week to pay for your rent. In this instance, you’ve got a cash shortfall.
You could turn towards a traditional bank for a loan. However, it would require an excellent personal credit plus collateral. It will also require a physical asset such as real estate that the lender could sell if you resort to a default. Maybe you could also qualify but can’t wait for several months for the loan to close.
That’s when you turn to an invoice factoring firm. The company agrees to buy your invoice for $14,700 in cash – $15,000 minus a 3% factoring fee ($450). The invoice factoring company advances 85% of the invoice (or $12,750) within a few days. The factoring company then collects the invoice when it is due, providing the remaining balance owed to you ($1,800).
Invoice Factoring Pros and Cons
As with other payment methods, invoice factoring also has its fair share of upsides and downsides. To better understand this concept and determine if it’s right for your small business, we’ll discuss the pros and cons of invoice factoring as stated in NerdWallet.com.
Invoice Factoring Pros
- Quick Cash
With invoice factoring, you can get immediate working capital to help cover any funding gap due to your slow-paying customers.
- Improve Overall Cash Flow
Keep your loyal customers on longer payment terms while still improving your cash flow. That way, you can grow your small business.
- Easier Approval
With invoice factoring, you can acquire the capital you need from companies that you might not be able to get (e.g., traditional banks). In most cases, invoice factoring companies only care about the value of the invoices that you’re looking to factor, as well as the credit-worthiness of your customers.
- No Collateral Needed
Invoice factoring is considered as unsecured financing. It doesn’t require any collateral. That means assets such as the real estate of inventory that the lender can seize if you fail to pay will not be necessary.
Invoice Factoring Cons
- High Cost
While it may provide you with fast cash, the service can be quite expensive at the same time. You also have to be wary of any hidden fees that might be included in the transaction. You can also add fees such as application fees, processing fees, credit check fees, or late fees. If your client is past due on his payment to you, this late payment may trigger an abrupt increase in your annual percentage rate. At the same time, it can also increase the annual cost of borrowing money with all the interest and fees included.
- You will Lose Direct Control
When you opt for invoice factoring, the overall control can potentially go to the invoice factoring company. Since the invoice factoring company may also collect on the invoices directly, you will need to make sure that it’s ethical and fair when dealing with your customers.
- Derailed Financing
Customer bad credit or weak financing can potentially stunt your financing. The invoice factoring company may need to verify the credit-worthiness of your customers. If the customers have a prominent record of late or missed payments, or if your businesses have weak revenue, you may not get approved for the financing. The invoice factoring company may also expect to get paid back – similar to other types of lenders.
- Non-Guaranteed Collection
There’s no certainty that the invoice factoring company will successfully collect your unpaid invoices. If it’s a recourse factor, the company may require you to buy back the unpaid invoice. Otherwise, you’ll need to replace it with one of more excellent value.
Invoice factoring is an important concept to consider, especially if its suitable for your business framework. If you’re struggling to make ends meet due to your customers’ delayed payments, you should consider invoice factoring.
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