Perhaps you’ve heard of invoice factoring, or had it recommended to you in a time when you were strapped for cash. If you have ever considered this type of financing solution and want to better understand the ins and outs, here is an overview to help you.
What is Invoice Factoring?
Invoice factoring is the process of selling your accounts receivable (invoices) to a factoring company at a discount. This financing solution is sometimes used by businesses that need cash for their short term working capital needs and can’t wait for their customers to pay.
How Invoice Factoring Works
Imagine your business has a contract with Walmart for $20,000 worth of your product. You know they are going to pay you eventually; however, their terms may be 30, 60, or even 90 days and you may find yourself with a lot of cash tied up in unpaid receivables.
This delay in payment might make it difficult for you to pay your everyday expenses and have the capital you need to grow your business. Unfortunately, the application and approval process for a traditional bank loan can be very tedious and time-consuming. Some small business owners who want to get capital quickly and spend their time focusing on their business resort to invoice factoring. In this example, a factoring company would buy your $20,000 Walmart invoice, give you 80-90% of the value, and collect the payment from Walmart directly.
How Does Factoring Compare to a Merchant Advance?
Sometimes factoring can be confused with merchant advance financing, and it is important to understand some fundamental difference between the two options in order to make the best decision for your small business. Merchant advance companies determine how much they will loan you by looking at your monthly credit card sales volume, and because they are integrated with the credit card terminal system, they ensure the repayment of the loan by taking the money straight from the payment system. Keep in mind that you are also paying Visa, Mastercard, Amex, or any other type of payment provider a 1-3% in fees on these type of sales.
Although invoice factoring can be expensive, a merchant advance is often even more expensive and riskier because it is based off your projected sales, not your accounts receivable.
Pros and Cons of Invoice Factoring
- Can Be Easy to Get Approved: Credit scores don’t play much of a role, because the invoices represent money your small business has already earned. Therefore, less weight is placed on your personal and business credit scores. If anything, invoice factoring lenders will be more concerned about the credit score of your customers and their ability to pay.
- Helps Keep Cash Flow Consistent: Timing is important when it comes to collecting payments, paying employees, and creating/ordering more product. For this reason, positive cash flow is vital, and factoring is a great way to speed up payment collection in times of need.
- Short Term Commitment (30-90 days): There are no quick and long term fixes in the business world, but depending on your situation, the short term nature of invoice factoring could be a temporary solution to a number of cash flow related problems.
- Limited Repayment Risk: Your business has already technically earned the money you receive from the factoring lender, so you know your clients will pay which makes invoice factoring a lower risk for all parties.
- High Costs and Fees: This is the most important con to consider. In fact, you could end up paying the same amount of interest for 30 days as you would for a 12 month short term business loan. That means your rate would be over 10 times higher if you used invoice factoring!
- Loss of Contact with Customers: You will no longer be dealing directly with your clients to collect their payments, instead that will fall to the factoring lender and you may have to take steps to ensure good and fair customer service is being maintained.
- Risk of Customers Not Paying is Your Responsibility: If your customers fail to pay, you will be required to buy back the unpaid invoice or replace it with one of equal or greater value.
- Not a Long Term Solution: Often invoice factoring is a fix for cash flow problems, and while it is effective in helping small businesses struggling in this area, it is far from a long term solution due to the high cost.
In conclusion, there may be instances where invoice factoring should be considered; however, you shouldn’t get in the habit using this financing solution regularly because you will end up consistently making less money due to the high costs that eat into your profit margins.
We encourage you to explore all your financing options and find the solution that best matches your business and needs. If you are looking for fast and affordable funding an online lender such as Lendified may be a good fit for you. Lendified offers short term business loans through a simple and easy online process. You can get a free quote in minutes and funding in as fast as 48 hours.