For many small businesses, one of the trickiest things to juggle, and one of the biggest risk factors of closure, is cashflow. With ups and downs in the market, unexpected costs, and other variables having an impact, it can often be difficult to stay on top of finances. Cashflow problems can also cause many entrepreneurs to shelve their plans for expansion, or miss out on potential sales during a busy period because of an inability to stock up on inventory.
If you run a wholesale business or other venture that lets clients pay on account, you might want to consider invoice factoring. This financing option involves “factors” providing invoice financing to organizations so that they receive money straight away, rather than having to wait for their customers to pay off accounts.
Read on for the lowdown on this finance type now.
Invoice Factoring: the Basics
Also known as “accounts receivable financing,” or “debt factoring,” invoice factoring converts the outstanding invoices of organizations (businesses or government departments) into cash. Factors gives their clients cash straight away, in exchange for taking ownership of invoices which will be paid by the original customers.
Factoring firms make their money by charging a fee on every invoice that they “buy.” Usually, most factors pay for invoices in two separate instalments. If you take advantage of factoring loans, you will traditionally receive an initial advance payment upfront, of about 80 percent of the invoice’s value, and then later receive the remaining 20 percent, less the factor’s fee, once the original customer pays off the invoice. This final amount is called the “reserve.”
Factoring businesses have certain criteria in place when it comes to choosing the organizations towork with. While this can vary from factor to factor, generally the factor will only agree to buy invoices from firms which it believes have credit-worthy customers likely to pay off accounts in full and on time. Factors will usually look for potential clients with no outstanding legal or tax debts/issues to be concerned with, too; and will put a maximum value limit on the amount of advances they will provide.
How the Process Works
The first step is to submit information to your chosen factoring firm to determine if it will deem your business eligible. The chosen firm will need to conduct due diligence on your customers, to see if they will be a low credit risk; and if approved, they will expect you to sign a financing agreement.
This contract will cover various details, but in particular will include information on which invoices are involved, who the customers are that will be paying the invoices, and the maximum percentage or dollar value that the factor will advance you.
Although most factoring firms set the initial advance at 80 percent of the value of the invoice(s), the range can vary between 70 and 98 percent. This number is worked out according to particular risk parameters used in financing calculations. It can be affected by the size of the transaction involved, the industry your business is in, and the type of customers (e.g., government departments, large corporations, or SMBs) you have.
Note that if you work with a factor, your customers will usually be sent a “notice of assignment.” This is a letter that notifies them that their invoices have been bought, and that their future payments need to be made to a new account. Once the factoring company has received the full amount of the invoice(s), it will then pay out the remaining balance of the transaction, with the pre-determined fee subtracted.
Pros and Cons to Keep in Mind
There are pros and cons to using accounts receivable financing. For starters, the major benefit of this system is that it allows businesses to get access to funds more quickly than if they were to wait for clients to settle accounts. This can make a huge difference to cashflow, plus reducestress levels and savetime because you no longer have to worry about chasing payments.
Other benefits include the fact that this financing style can work out cheaper than getting a bank loan, merchant cash advance, or other injection of funds, and is a flexible process. If you only need to utilize a factor for a short time (e.g., to cover a large invoice you’re waiting on payment for), you can do so. Unlike with more traditional financing, you won’t be locked into anything for a set period. You can simply choose to use the service as and when it suits you.
It is a good idea to keep potential factoring risks in mind, too. For example, since most factors handle the collection of invoice payments once they take over a bill, they end up dealing with your customers. As such, you won’t have control over how clients are interacted with, and could potentially receive bad word of mouth, or even lose customers, if factors aren’t friendly or respectful. Also, be on the lookout for potential hidden fees. Factoring firms can sometimes charge late fees if invoices aren’t paid on time, or add costs for credit checking or processing an application.