You’ve probably considered or heard of invoice factoring if you own a small business with slow-paying customers or occasionally limited cash flow. An invoice factoring company converts unpaid invoices into quick cash to help finance your small business’s short-term needs. At the same time, invoice factoring can be difficult to grasp at first, which is especially important given how it differs from most other business financing options.
In this article, we’ll go over everything you need to know about invoice factoring financing and its benefits to small business owners.
What Exactly Is Invoice Factoring?
Invoice factoring is a type of invoice financing in which you sell some or all of your company’s outstanding invoices to a third party to improve cash flow and revenue stability. An invoice factoring company will pay you the majority of the invoiced amount immediately and then collect payment from your customers directly. Invoice factoring has advantages and disadvantages, which we will discuss in this article. Accounts receivable factoring and debt factoring are other names for invoice factoring.
How Does Invoice Factoring Work?
Invoice factoring companies may operate differently, but the process is generally as follows:
#1. You Submit An Application For Invoice Factoring
The invoice factoring company will examine your clients and draft an agreement for an ongoing relationship in which you will be able to submit invoices.
#2. You Send The Client An Invoice
You will send your invoices to your client once you have completed your work or sold your product.
#3. You Send The Bill To A Factoring Company
You will resubmit the same invoices to the factoring company, usually through an online portal.
#4. The Funds Are Advanced To You By The Factoring Company
The funds will be transferred to you via ACH or wire transfer based on the advance rate in your contract, which is typically 70% to 90%.
#5. The Invoice Factoring Company Is Paid By Your Client
You must notify your client or have them sign an agreement so that they understand they must now pay the invoice factoring company rather than you.
#6. After Fees, The Factoring Company Sends You The Remainder
When your client pays, the invoice factoring company will send you the balance of the invoice less the fee.
Example Of Invoice Factoring
When you submit an invoice for factoring, the factoring company will not pay you the entire invoice amount at once. Instead, you’ll receive two payments: an upfront payment based on your advance rate and a follow-up payment after your client pays the invoice factoring company.
What is the cost of invoice factoring? It is determined by the factor rate, which is also known as the “factoring fee” or “discount rate.” When the invoice factoring company sends you the second payment, they will deduct this pre-determined fee from it.
Here’s an illustration of how it works:
| Invoice value | £10,0000 |
| Advance rate | 90% |
| Factoring rate (discount rate) | 2% |
| Upfront cash payment | £9,000 |
| Remainder payment | £800 |
| Total cost | £200 |
In this example, you charged a customer £10,000 and agreed to accept £9,800 from an invoice factoring company to receive the majority of the funds sooner rather than later.
How To Qualify For Invoice Factoring
One of the reasons invoice factoring is so popular is that it is easier for many business owners to obtain than a business loan. You may be eligible if you run a business that sends out invoices rather than making mostly retail sales. The following are the primary factors that invoice factoring companies will consider:
#1. The Invoice History
You’re a good candidate if you consistently work with a few companies that always pay their invoices on time (even if it takes a while, such as on a net-90 billing cycle).
#2. Credit Rating
Invoice factoring companies may look at your credit score, but the credit of your customers is more important because those invoices are what you’re selling.
#3. Minimum Monthly Income
Each month, you may be required to submit a certain number of invoices for factoring, either from all of your customers or from specific pre-approved customers.
#4. Time Spent in Business
The longer you’ve been in business, the easier it is to demonstrate your ability to roll with the punches, and you may also be able to point to a longer invoice history with specific customers.
Benefits Of Invoice Factoring
Invoice factoring financing has a lot of benefits for small business owners who find it hard to get a loan from the bank. Some of these benefits include:
#1. Improved and More Predictable Cash Flow
By using invoice factoring, you can have the majority of your invoices paid almost immediately rather than waiting for the money to come in (possibly after extensive chasing on your behalf). It improves business planning and forecasting and allows you to capitalize on opportunities that would otherwise be out of reach.
#2. Improved Chances of Survival for Your Business
Better cash flow increases your business’s chances of survival. Many businesses fail due to insufficient cash flow, and invoice factoring can help you avoid this fate if you use it wisely.
#3. Cheaper And Easier to Obtain Than a Bank Loan
Invoice factoring is typically less expensive and easier to obtain than a bank loan, making it ideal for short-term funding needs. It also relieves you of the burden of debt management. That could be a significant savings, depending on the size of your customer base.
#4. Reduces Your Business Overhead
Invoice factoring services may help you save money on your business expenses. While invoice factoring has fees, they may be less than the cost of hiring dedicated credit control staff. Invoice factoring may also boost morale in your accounts department, as chasing down payments is often stressful work.
Disadvantages Of Invoice Factoring
There are some disadvantages to factoring that a business should consider before selling an invoice to a third party. The following are some disadvantages:
#1. Unsuitable For Businesses With Few Customers
Invoice factoring is not appropriate for a small business with only a few main customers. Companies that prefer to spread their risk as widely as possible They try to avoid sending a large number of invoices to a small number of customers.
#2. Requires a Big Commitment
It is sometimes possible to factor in a small number of invoices (known as selective factoring or spot factoring), but most factoring companies will want to take over the majority of your accounts receivable. They may also try to lock you into a long-term contract of two years or more. This is necessary from their standpoint, but it means you can’t just dip in and out of invoice factoring whenever you want. It’s a significant business decision.
#3. Costs More If Your Customers Are Risky
 Factoring companies make every effort to accurately determine the risk of late or non-payment of debt. This means they will carefully evaluate your customers. Their fees will reflect their assessment of credit risk; if you or your customers are deemed high-risk, your fees will be high.
#4. Extra Costs If It Doesn’t Work
If your clients turn out to be poor payers, you may have to pay additional disbursements. If a customer fails to pay, you may be required to repay the amount that the invoice factoring company has already paid you unless you pay an additional fee for non-recourse factoring. To ssummarize do not expect a factoring company to take over your bad debts for free. They, like you, are in business to make money.
#5. Can Harm Customer Relationships
When you factor in invoices and the credit control is handled by the factoring company, you are also giving up some control over your customer relationships. If the invoice factoring company pursues the debt coldly or aggressively, your customers may be put off working with you in the future. They may also interpret the involvement of an invoice-factoring company as an indication that your business is struggling.
How Much Does Invoice Factoring Cost?
Invoice factoring is one of the simplest types of business financing to qualify for, and it allows you to get cash quickly – much faster than most clients pay their invoices. The disadvantage is that invoice factoring is one of the most expensive types of business financing.
#1. Advance Rates
While this isn’t a direct cost, most factoring companies will only advance you up to 80% or 90% of the invoice value. The remainder is held in reserve by the invoice factoring company until your client pays the invoice, after which it deducts interest and fees.
#2. Interest
Interest rates for invoice factoring companies typically range from 0.5% to 4% per month, which is significantly higher than interest rates for more traditional financing.
#3. Late Payment Fee
 If one of your clients pays their invoice after it is due, especially in a small business with few main customers, invoice factoring companies may charge you a fee.
#4. Fees For Returned Checks
 If a client pays the invoice factoring company but their check does not clear, the factoring company may charge you a penalty.
#5. Fees For Wire Transfers
Some factoring companies charge fees for processing wire transfers, whether they are distributing advances to you or receiving payments from your clients.
Invoice factoring costs can be much higher than other financing types. There are usually some ways to cut costs, but these vary depending on the invoice factoring company. Borrowers in certain industries, such as healthcare, may, for example, receive lower interest rates than others. If you handle payments electronically, you may also save money. Naturally, the faster your clients pay their bills, the lower your fees will be.
What to look for in an Invoice factoring company
Factoring companies, like other lenders, come in a wide variety of sizes. Each has its own set of strengths and weaknesses, as well as specialities. If you believe invoice factoring could be a good way to help you finance your business, consider the following factors when selecting a lender:
#1. Industry Expertise
Most factoring firms specialise in one or more industries or business sizes. Find someone who understands your industry and your requirements.
#2. Interest Rates Are Low
 Invoice factoring can have very high interest rates, so make sure you understand the rates your potential invoice factoring company charges in comparison to its competitors.
#3. High Advance Rate
Factoring companies limit the amount of money they will advance to borrowers based on the size of the invoice. Work with an invoice factoring company that allows you to access as much of your money as possible as soon as possible.
#4. Online Invoice Management
 A good invoice factoring company will have an online platform where you can log in and check the status of invoices you’ve factored, as well as submit new invoices for factoring.
#5. Simple Renewal Process
Once you’ve been approved to work with an invoice factoring company and one of your clients has been approved, the process of factoring additional invoices should be quick and easy.
Is Good Credit Required for Invoice Factoring?
There are no personal credit requirements for invoice factoring because it is based on the credit history of the invoiced business.
Who Can Benefit From Invoice Factoring?
The type of business you have, where you are located, the industry you work in, and whether or not you have any outstanding liens or tax balances all play a role in whether or not you are eligible for invoice factoring. You’ll also need to work with creditworthy customers who aren’t in danger of failing to pay their outstanding receivables.
Is Income From Factoring Taxable?
Payment received on outstanding invoices is reported as income when the factoring company owns the accounts receivable. Payment from the factoring company is not taxable income, however, when your business retains ownership of the accounts.
Is Invoice Factoring Regarded as a Loan?
Invoice factoring financing is similar to a traditional secured loan in that it has set payment terms and interest charges accumulate on outstanding balances, but the loan is secured by one or more invoices. The cash that the company receives through invoice factoring is not a loan.
Why is Invoice Factoring Dangerous?
Working with a factoring company gives a third party control over certain financial aspects of a business. This is because using a factoring company to pursue and collect invoices and deficit funds violates the privacy of both customers and business owners.
Conclusion
Cash flow issues are an unavoidable business impediment. Invoicing factoring is one solution to the problem. A business receives the majority of its value within a few business days by selling unpaid invoices to a third-party factoring company. It will then have enough cash to fulfill new orders, cover its expenses, and pursue growth opportunities.
When the factoring company collects payment from the customer, the business receives the balance of the invoice’s value. Invoice factoring is an appealing financing option for many small business owners who cannot or do not wish to work with banks.
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