Cash flow can be a problem for businesses that offer generous payment terms to their clients. Many offer terms of between 30 and 90 days, which means they may not receive the cash they are owed for up to 3 months.
Invoice factoring may help solve this cash-flow problem.
What is invoice factoring?
Invoice factoring is a form of financing where a business sells its outstanding invoices to another company, which then collects the invoices for the business for a fee. Invoice factoring is basically a cash advance – it’s a way for small businesses to get cash, without having to wait for a customer to pay their invoice.
Once you’ve sold your invoices to the invoice factoring company, they’ll pay you a percentage of the value of those invoices straight away – you won’t have to approach a lender, a financing company or a bank.
How does invoice factoring work?
Common types of invoice factoring
- Spot factoring: You sell your invoices to a third party for a one-time deal.
- Recourse factoring: This is the most common type of factoring. You agree to buy back any invoices the factoring company cannot collect.
- Non-recourse factoring: The factoring company assumes the risk of the customer not paying the invoice. The factoring company charges higher fees to cover the cost of the risk.
The invoice factoring process
- A business provides goods or services to a customer.
- After completing the transaction, the business sends an invoice to the customer.
- The business then sells the invoice to a factoring company before the invoice is due. The company usually pays 80% of the invoice amount to the seller in advance.
- The customer pays the invoice as usual – but to the factoring company, not the original business. The factoring company follows up if payment is late.
- The factoring company deducts a fee and pays the remaining balance to the business.
Invoice factoring pros and cons
Invoice factoring has many advantages. Firstly, you’ll have quick access to funds – factoring companies usually approve the money more quickly than bank loans and traditional financing, and you can access your accounts receivables more quickly. Secondly, invoice factoring isn’t a loan (it’s a sale), so it doesn’t affect your creditworthiness – there’s no credit check and you don’t need any collateral. And thirdly, you can offer longer payment terms to customers and still receive payment.
The main disadvantage of invoice factoring is the risk it introduces. It can be an expensive way to gain working capital because factoring companies tend to charge high fees, and may also charge high interest rates. You also lose control of your invoices, and could even have to buy them back (be open to a ‘recourse factor’) if the invoice isn’t collected.
- You can’t use invoice factoring if your business doesn’t issue invoices.
- You may not qualify for factoring if your customers have bad credit, a poor payment history, or if they rely too much on their credit card.
- Because factoring companies can pursue unpaid invoices aggressively, you risk damaging your relationships with clients. Factoring is therefore risky if you’re a small business with a limited client pool.
Choosing a factoring company
To choose the best factoring company for your organization, ask yourself these questions:
- Does the company have experience in your industry? Look at the invoice financing services they provide and find out how specialized their services are.
- Think about your business needs and the type of factoring company you need. What is their factoring process?
- How flexible are the terms in the factoring agreement? Don’t just consider the factoring fees – look at the length of the contract, cancellation fees and the repayment schedules too. Consider the company’s factor rates, especially the discount rate.
- Each company structures its fees differently. Choose one with a fee structure that suits your business.
- How good is the company’s customer service?
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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