Cash flow can be a problem for companies that offer generous payment terms to their clients. Most companies offer 30-day to 90-day payment terms for invoices, which means they may not receive the cash they are owed for up to three months.
A recent Xero survey reported that 48% of small US businesses say that inflation has had an extreme or high impact on their cash flow over the last six months, with 44% saying they expect that inflation will have an extreme or high impact over the next six months. So some businesses are looking for solutions to the cash flow issue.
Invoice factoring can potentially solve that problem. For a fee, businesses sell their invoices to a factoring company, handing over the invoice collection to a third party. That company pays the seller a percentage of the value of the invoice, immediately boosting the seller’s cash flow.
What is invoice factoring?
Invoice factoring is a form of financing where a business sells some or all of its outstanding invoices to an outside company, which then collects the invoices for the business. One reason a company might choose invoice factoring is to improve cash flow.
Invoice factoring is basically a cash advance. Companies frequently issue invoices with 30-day to 90-day payment terms. That means they may not receive payment from customers for a month or more. Invoice factoring, similar to accounts receivable factoring, is a way for small businesses to get access to immediate cash before a customer pays an unpaid invoice.
With invoice factoring, your business sells invoices to a third party (the invoice factoring company), which collects the amount due on the invoices. You receive immediate cash from the third party for those invoices so that you don’t have to wait for the cash to come in.
For businesses with limited cash flow, invoice factoring gives them business financing without approaching a lender or taking out a business loan from a financing company or a traditional bank. Another reason a business might choose this type of financing solution is that it doesn’t impact the business’s credit score, as it is a sale, not a loan.
However, there are disadvantages with invoice factoring. The factoring company charges a fee for their service, and they can be high. So, you might choose a less costly form of financing if you qualify, such as a small business (SBA) loan or a traditional line of credit.
Factoring only works with businesses that issue invoices. Also, if your customers have bad credit, a poor customer payment history, or rely too much on their credit card, you may not qualify for factoring.
Lastly, factoring is not a good funding option for small business owners with a limited pool of clients. Factoring companies can pursue unpaid invoices aggressively. This can make customers feel uncomfortable doing business with you and may damage the relationship you have with those customers.
How does invoice factoring work?
Here are the steps in 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 sells the invoice to a factoring company before the invoice is due. The factoring company usually pays 80% of the invoice amount upfront to the seller.
- The customer makes the invoice payments as usual but to the factoring company, not the original seller. The factoring company follows up if there is a late payment.
- The factoring company pays the remaining balance to the seller after deducting their fee.
Types of factoring
The three common types of factoring are spot factoring, recourse factoring, and non-recourse factoring:
- Spot factoring: You sell your invoices to a third-party provider 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.
Pros of invoice factoring
There are significant advantages to invoice factoring, particularly for larger companies that need to enhance their cash flow or need better credit standing.
- You gain faster access to your accounts receivables.
- You can offer longer payment terms to customers but still receive payment.
- There’s no impact on your creditworthiness, and no credit check is required.
- You’re approved within days. While applications for bank loans and traditional financing take time, factoring companies usually approve the money within one or two business days.
- You don’t need any collateral.
Cons of invoice factoring
The main disadvantage to invoice factoring is the risk involved. It can be an expensive way to gain working capital because factoring companies tend to charge high fees. Here are some other cons of invoice factoring:
- Factoring costs can be expensive. That includes high service fees, known as factoring fees.
- You may also face high interest rates.
- You lose control of your invoices.
- Collection of the invoice may not happen, in which case you could be open to a recourse factor, in other words, buying back the invoice.
Choosing a factoring company
Choose the best factoring company for your organization by considering the following:
- Does the company have experience in your industry? Look at the invoice financing services they provide and find out how specialized their services are.
- Consider your needs and the type of factoring company you need. What is their process for factoring?
- 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 repayment schedules too. Consider their factor rates, especially the discount rate (these can vary between one and six percent).
- How responsive is their customer service?
- Each company structures its fees differently. Choose one with a fee structure that suits your business needs.
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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