What is invoice factoring for small businesses?
Thu | April 2022
Are you a business owner waiting for customers to pay their outstanding invoices? You are not alone. Finding alternatives to aid this is very common, and invoice financing can help.
As a small business owner, there are a wide variety of financing options for your business. You have probably been looking for different ones to find the one that best suits your needs. Invoice factoring is a trendy business loan alternative since it's suitable for businesses that need to wait longer than desired for their invoices to be paid.
In this article, we will walk you through the basics of invoice factoring, how it works, and give you the tools to decide whether it is the right business funding option for your business need.
What is invoice factoring?
Invoice factoring, is a business financing transaction in which a business sells its invoices (or receivables) to a third-party financial company, commonly referred to as a factor.
First, you receive funds and then pay the factoring company back by selling a percentage of your unpaid invoices. This way, since it's a sale, not a loan, you are not impacting your credit as you would with traditional bank financing. It allows small businesses to unlock the cash value of their invoices long before their customers pay their bills.
There are two types of invoice factoring listed below:
Recourse factoring: This type is the most common type of invoice factoring. With recourse factoring, your company must buy back any invoices the factoring company didn't collect to pay back for funding.
Non-recourse factoring: Alternatively, with this type, the factoring company assumes most of the risk of non-payment by your customers (although this does not mean you are not responsible for any pending payments).
The process for invoice factory is straightforward, let's say that:
Your business provides the common good and services it always has.
You then send the invoices to your customers for those goods or services.
Once you've raised several invoices, you "sell" them to the factor.
The factor then verifies these invoices and typically pays around 80-90% of the values.
The factor charges your customers directly.
They then pay your company the remaining amount, discounting their fee.
What is a factoring company?
A factoring company (or "factor") is the financing partner of your choosing that purchases your invoices in exchange for cash.
Once approved to work with them, you can sell your outstanding invoices to boost working capital, avoiding the delay caused by extended payment terms. Usually, the factoring company verifies your invoices, funds up to 90% of the invoice face value, and then collects those invoices directly from your customers.
Afterward, they collect the money on the standard payment terms from your end customer to release the remainder of the invoice value to you, minus a small factoring fee – typically one to five percent.
Invoice factoring example
Let’s give an example to show you how invoice factoring works:
Your company has a $10,000 invoice and expects your customer to pay it within the next 30 days. Currently, your cash flow is not in good standing, and you have some urgent expenses to attend to. So, to resolve this instance, you decide to sell that invoice to a factoring company.
Instead of waiting 30 days to cash in the entire $10,000, you'll get an advance of $8,000 deposited in your bank account. In this instance, you're selling your invoice to a factor with a 10% fee.
Factoring Fee (-10%)
Initial Advance (80%)
Remaining Advance (10%)
Advantages and disadvantages of invoice factoring
To find out whether or not invoice factoring is the best choice for your business, below are some advantages and disadvantages of factoring:
Invoice factoring advantages:
Immediate access to cash for your business.
Easier and faster approval than traditional bank lending.
No impact on your credit score.
More flexibility of payment time for your clients.
Limited risk for you since you won't need to worry about valuable assets being seized if the customer fails to pay.
Helps manage overdrafts.
Invoice factoring disadvantages:
There's a stigma around which companies need this service.
Access to funds relies on your customers' credit scores.
Reduced profit margins for your business.
High costs and interest rates.
Possible hidden fees.
The collection isn't guaranteed, as it depends on your customer.
Invoice financing vs. merchant cash advances
Invoice financing can be a good choice, especially if long receivables are part of your typical business cycle. However, this is just one lending option amongst many, so it's best to reach out to funding providers and see what best suits your needs.
Many think Merchant Cash Advances (MCA) is the same as invoice factoring. The truth is that merchant cash advances are real advances against a business's expected future revenue. This is an easy way for smaller companies to quickly get a lump sum of cash. The advance is then paid back by an automated withdrawal of a percentage of your daily bank balance (typically daily or weekly, but terms can vary).
If you're looking for an alternative to invoice factoring, you can check if you pre-qualify through an online form that will only take minutes to complete. Once you get approval, you can access working capital within 72 hours.
You won't need to worry about set-in-stone payback terms because we offer flexible payment terms that can easily align with your business cash flow. This means you'll pay less during slow growth periods and then catch up by delivering a more significant percentage during times of high-volume revenue.