Invoice Factoring 101
So, you’ve heard about invoice factoring but aren’t sure how it works or how it could help your business? Then, you’ve come to the right place.
1. What is Invoice Factoring?
Invoice factoring is a business-friendly alternative to traditional finance methods that gives your company fast access to the working capital you need, without any strings attached or any debt to repay. For example, your business sells its unpaid invoices to a factoring company.
Within 24 hours, the factoring company issues your business an advance on the invoice up to 95% of the value. Your customers send the payment to the factoring company on the terms you already have in place with them. Nothing changes except the payment address.
Invoice factoring is also known as accounts receivable factoring or A/R financing.
2. How Does Invoice Factoring Work?
Invoice factoring converts your open invoices into immediate cash, saving you from waiting 60 to 90 days or more for payment from your customers. In addition, you have the flexibility to factor whichever and however many invoices you need to have cash on hand, following the short process below:
- Once you set up your account with the right factoring company, you can begin to submit copies of your unpaid invoices to the invoice factoring company. Your work must be completed and delivered to begin factoring invoices. Continue to invoice your customers as usual and email or fax a copy directly to the factor.
- You will receive a cash advance within 24-hours. The factor will verify your invoices and deposit as much as 95 percent of the invoice amount directly into your bank account. For the transportation industry, advances can be as high as 98%.
- Continue work per usual while the factoring company collects from your clients. Your factor will engage in active collection efforts, allowing you more time to serve your customers and focus on the big stuff: growing your business.
- Repeat the process as many times as you want, with as many different clients as you want. You can factor one particularly slow-paying client or all of them! The choice is totally up to you.
3. What are the Benefits of Factoring Invoices?
When you begin invoice factoring, you are taking control of your cash flow. But, more importantly, you are starting a relationship with your factor that can help your business in even more ways:
- Credit and background verification: It is critical to work with reliable customers to build a solid payment history and turn your sales into revenues. However, credit and background checks are expensive to run and can quickly eat away your working capital. Your invoice factoring company will provide these checks at no additional charge to you, so you can be confident in your customers’ quality and address any issues before they affect your business.
- Credit-building and repair: You can qualify for a competitive invoice factoring program even if your business credit is less than stellar. In addition, by factoring your open invoices, you can cover your daily operating costs and pay down current debt to rebuild your credit rating. Start-ups qualify as well, so when your business is brand-spankin’ new, factoring can help you hit the ground running for long-term success.
- Money-saving opportunities: Competitive rates are not the only way invoice factoring can save your company money! By negotiating early-pay discounts or other payment incentives with your suppliers, you can put your rejuvenated cash flow to good use. Depending on how much you factor, you may even qualify for a volume discount that will reduce your rates further.
- Consistent and steady cash-flow: Ups-and-downs are good for one thing only: rollercoasters. Factoring your invoices can help you regain complete control of your working capital. Whether your business is subject to seasonal fluctuations, or you are just tired of waiting 30, 60 or even 90 days for your money, invoice factoring can help you regulate cash flow.
- Ability to Grow: Your business might be steady, but invoice factoring can allow for growth in lots of different ways:
- Increased marketing efforts
- Better contracts with larger clients
- Technology upgrades or investments
- New hires or training programs for existing employees
- Site expansion or re-location
- No Added Debt: Unlike a traditional loan, invoice factoring won’t add more debt to your balance sheet. Quite the opposite actually, factoring can help you get the extra cash you need to pay off old debts. There’s no added interest or money to pay back. There’s no added interest or money to pay back. It’s already your money, factoring just helps you get it in your bank account faster.
4. What Types of Businesses Use Factoring to Finance Companies?
Factoring goes as far back as the Roman Empire, where factors helped business people, especially farmers, grow their businesses. In more modern times, factoring has been used in the clothing and textile industry to finance transactions, help pay for raw materials and accept larger purchase orders. Nowadays, almost any and every industry you can think of uses factoring. To name a few:
5. How Do I Start Factoring? What Do I Need?
The initial paperwork to start the invoice factoring process is relatively easy to obtain and complete:
- A short application, sent over by the factoring company
- Articles of Incorporation
- Copies of invoices you’d like to factor
- Customer list
Once you send in the required documentation, most invoice factoring companies can approve you for funding in as little as 24 hours. Businesses of all sizes are generally eligible, regardless of their financial or credit situations, because the factoring company will base its funding decisions on your customers’ creditworthiness.
If you have a less than perfect personal credit score, you can still qualify for invoice factoring. Because your clients are ultimately responsible for paying the bill, most factors are more concerned about your customers credit, not yours.
Common Invoice Factoring Terms
Don’t get confused or discouraged because you don’t speak the language. Let us help you translate:
- Account Debtor: Your customers
- Accounts Receivable Aging Report: A report showing the amount of unpaid receivables as well as the length of time they have remained unpaid
- Accounts Receivable Factoring: AKA invoice factoring. These two terms mean the exact same thing and are used interchangeably
- Discount Rate: A percentage of the invoice charged as a fee by the factor for advancing funds
- Due Diligence: The background research conducted by the factor to assess potential customers
- Factoring Advance Rate: A percentage of the invoice advanced to the client within 24-hours. usually between 80-95% of the total invoice amount
- Factoring Broker: a third-party who connects business owners with an appropriate factoring company to meet the small business’s needs and goals
- Lien: Assigns the right to claim possession of property until a debt is paid back
- Non-Recourse Funding: Sometimes customers don’t pay their invoices within the agreed-upon payment terms…or worse, they never pay their invoice! With non-recourse funding, the factor would assume all responsibility for lost funds. Because of the apparent risk, non-recourse factoring is more expensive
- Recourse Funding: If your client does not pay within the agreed-upon payment terms, your company must buy back the receivables
- Reserve: The amount of the account receivable held back by the factor until full repayment by the customer
- Spot Factoring: A one-time agreement that gives staffing companies the ability to factor a single invoice
Factoring and Your Customers
First, it’s important to remember and emphasize that factoring is NOT a bad thing, and your factoring company is NOT a collections agency. Your factoring company wants to maintain a good relationship with you AND your customers and offer the best customer service possible. Your factor wants the process to be just as seamless as you do. Here’s how it generally works:
- Once you decide to start factoring, your Account Manager will work with your debtors to verify that they are indeed a customer and, let them know their change of remittance address has changed.
- Remember: this is COMMON. Your client has to pay their invoices anyways, so it’s of no difference to them where they send it.
- Your Account Managers are experts at this: they will assure your clients that they are simply taking over your accounts receivable and managing your invoices.
- That’s it! Most likely, nothing will change between you and your customers. You will still invoice them per usual, and they will send the payment to a new PO box. If problems do arise, your Account Manager will be there to help work out any issues.
6. What to Look for in a Factoring Company
There are many factoring companies out there, but they all have different specialties, fee structures, locations, and more. Consider these points when comparing options:
There’s no such thing as a free lunch, and that’s true for factoring as well. Yes, it does tend to be more expensive than a traditional bank loan, but beggars can’t be choosers and some working capital is better than none at all. Make sure you understand the overall cost to factor, and the smaller, more hidden fees your factor may charge. These can include application costs, account set-up fees, costs to research any liens, credit reports, charges for money transfers, or last minute fundings. It’s important to go with a factor you feel entirely comfortable with and can trust. Not all factors charge for the same things or have hidden fees.
We can’t stress this one enough! First, make sure you read the fine print of your contract. There’s nothing worse than starting to factor with a company only to realize you are locked into terms you do not like. These terms may include a limit on how much you can factor a month or chain you to a specific factoring company for the rest of your life. Long-term contracts DO exist and if you try to get out of them, be prepared to fork over big bucks. Make sure you’re crystal clear about how long you’re signing up for, how much you can factor a month, and which of your clients are eligible for factoring.
Is there anything worse than a business with bad communication? Yes, a business with lousy communication that also handles your money! When it comes to your business and money, you want someone that isn’t going to take two days to respond to your email or inquiry. Of course, every factor will say they have great customer service and communication but pay attention! Pay attention to how and when your potential factoring companies respond. Would you want them responding in such a way to your customers? If the answer is no, move along. There are plenty of fish in the factoring sea!
If you broke your arm, you wouldn’t see an eye doctor, so why would you do the same thing with your factoring company? Yes, there are good companies that do general factoring, but try to find one in your niche. There are many factoring companies specializing in specific industries, which means they’ll understand a lot about your business model from the get-go. Additionally, they may offer programs specific to your industry, such as back-office support or fuel cards, which may be especially beneficial or an added bonus to deciding to factor!
Common Misconceptions about Invoice Factoring
Invoice factoring is only for struggling businesses with money problems
In truth, invoice factoring is a way of managing your cash flow more effectively and efficiently. The process lets you use your customer invoices as collateral in exchange for cash, which the factoring company makes back by collecting on the invoices.
Many businesses use invoice factoring to expand their businesses because the invoice factoring process is quicker and typically simpler than trying to apply for a business loan from a bank. It also frees up time you would otherwise spend chasing invoices and lets you focus on the growth and success of your business.
Factoring looks bad to your businesses customers
As mentioned above, your business can expand using invoice factoring services. Even if that is not the purpose, working with a factoring company should not be construed as bad in your customer’s eyes. Factoring is a method of outside funding. This type of capital is typically challenging to secure, so it is good if your business qualifies. However, factor approval is basically dependent on the creditworthiness of the business’s customers.
Invoice factoring has very minimal effects on your clients. Rather than making checks payable to your business, invoice factoring has your client write them out to the factoring company, and the factoring company will take care of informing your customers of the change.
Factoring companies will harass your customers or clients with collection calls
This notion is completely untrue; a factoring company benefits the most when the relationship between business and customer is good. To harm this connection would be to shoot itself in the foot. A good factoring company will be courteous and conscientious when following up with clients about payment on invoices.
Factors will strive to make the payment process more efficient and occasionally call to remind customers about a payment owed. However, in no way will they be harassing your customer.
Factoring is too expensive and will take a huge cut of value from your invoices
While factoring invoices does come with a fee, the exorbitant price tag many think factoring comes with simply isn’t there. Factoring costs are competitive and usually more reasonably priced than other financing options, with faster approval time as well. That said, a bank loan may come cheaper in the short term, but the process will take longer and the interest due will be higher.
With factoring, you are selling your business’s invoices and the factoring fee really can’t compare to the amount you’d owe on your borrowed money at the end of your loan period with a bank. Factoring will advance up to 90% of the value of your invoices upfront, and the rest is given to you when the customer pays their bill, minus a small fee the factoring company takes based on the turnover.