The Beginner's Guide to Invoice Factoring
Introduction
If cash flow is an issue for your company, you’re not alone, and it helps to be aware of available financing options.
Invoice factoring is a quick and simple cash flow solution, but it can sound confusing at first. This guide will show you how easily factoring can be used to increase cash flow AND efficiency for your business. Here’s what’s included:
What is Invoice Factoring?
Invoice factoring is a type of business financing that occurs when a company sells its invoices (Accounts Receivable) to a factoring company in exchange for cash. The company benefits from immediate cash flow when it would otherwise have to wait for NET payment terms (i.e. NET30, NET60, etc.). The factoring company benefits from the factoring fee charged to provide the service.
In short, factoring is a cash flow solution that speeds up payment on your outstanding invoices.
How Does Invoice Factoring Work?
Here’s the easy way to think about factoring: Make a sale. Get paid. The factoring company takes care of the rest. In short, you get fast cash plus outsourced billing and collections.
Here’s how it breaks down:
Complete a sale and delivery of product or service to your customer.
Sell the invoice to the factoring company.
Your company gets paid the same day (Advance Amount).
The factoring company invoices your customer on your behalf (the factoring company monitors your invoice status and follows up on collections where necessary).
Your customer pays the factoring company.
The factoring company forwards you the remaining Reserve Amount.
Key Terms:
Factoring Fee: The fee charged by the factoring company to purchase the invoice. This may also be referred to as the Discount Rate. It is usually represented as a percentage in a factoring agreement (i.e. typically 1 - 5%).
Advance Amount: The initial amount paid by the factoring company at the time of invoice purchase, as determined by the Advance Rate in a factoring agreement.
Advance Amount = Advance Rate x Invoice Price
Reserve Amount: The remaining amount paid by the factoring company at the time an invoice is paid in full.
Reserve Amount = Invoice Price - Advance Amount - Factoring Fee
Let’s take a look at an example, assuming a Factoring Fee of 3% and Advance Rate of 90%:
Day 1: You sell $1,000 worth of widgets to ABC Company, who has NET30 payment terms. You decide you want to get paid faster, so you sell the invoice to the factoring company. You get paid $900 the same day you deliver the product.
Advance Amount = Advance Rate x Invoice Price
Advance Amount = 90% x $1,000
Advance Amount = $900
Day 30: ABC Company pays the factoring company in full. The factoring company deducts its factoring fee and pays you the remaining Reserve Amount of $70. The factoring company keeps its Factoring Fee of $30.
Reserve Amount = Invoice Price - Advance Amount - Factoring Fee
Reserve Amount = $1,000 - $900 - $30
Reserve Amount = $70
Why Do Companies Use Factoring?
Cash Flow
Companies use invoice factoring when there is a shortage in the cash needed to operate the business. This may be due to factors such as:
Being denied a bank loan or access to a line of credit
Downturn in the business
Cyclical sales cycles
Slow-paying customers
Special projects or initiatives that require investment
When cash flow shortages occur, factoring can help you overcome cash flow issues. Rather than waiting for payment on unpaid invoices, factoring advances the cash tied up in your Accounts Receivable without taking on debt or losing equity. You’re simply selling one asset (A/R) for another asset (cash).
Business Efficiency
Factoring companies provide invoicing and collections services that free up your company resources. In cases where you choose to factor all customer accounts, your Accounts Receivable operation essentially becomes outsourced to the factoring company, which may even lead to personnel savings. In this way, factoring is more than a cash advance on your unpaid invoices - it’s an operational tool that can also save your business money.
Limiting Risk
One important thing to remember is that a factoring company’s success depends on its customers’ success. In this way, factoring companies have an interest in helping you limit the risk of slow-payment, or worse yet, non-payment.
Credit checks and analysis are a standard feature of a factoring partnership. Factors will approve or reject invoices based on your customers’ credit. While this may sound limiting at first, it is designed to protect your company from customers that have a risky credit profile.
Another way risk is mitigated is through the factoring company’s collections services. Good factoring companies have strong operational procedures that track invoice status and raise alerts when needed. It should be the goal of a factoring company to be paid as quickly as possible (according to your payment terms) for a smooth Accounts Receivable process that limits the risk to your company.
What are the Pros and Cons of Factoring?
Advantages of Invoice Factoring
Quick and easy approval: Factoring approval is typically done within 1-2 days, if not within just a few hours. The reasons for this, as compared to more traditional forms of lending, include:
Approval based on your customers’ creditworthiness: The factoring company will be repaid by your customer(s). Therefore, factoring companies are concerned with your customers’ business credit. This means your approval is not based upon your credit score, profitability, length of time in business, collateral, and in some cases, background issues.
Less paperwork: Due to the above, there is typically not a need for an in-depth review of all of your financial statements. In most cases, a factoring company requires a short application and a few documents to verify your identity/background, company structure, and customers.
Fast cash: Once your company is approved and your account is setup, you can typically begin funding within a few days, if not the same day. This depends upon how quickly the factoring company can get your account set up with your customer(s).
Avoid debt / No repayment plan: Because factoring is not a loan, there is no liability (debt) created, so there is no need for a repayment plan. The factoring company just accepts their factoring fee upon being repaid by your customer.
Increased efficiency: Outsourcing the administrative tasks of invoicing and collections frees up time to focus on initiatives that grow your business.
Unlimited funding growth potential: With factoring, your funding grows as your company grows. So long as your customers maintain their credit and remain current on their payments, there is no cap like there would be with more traditional forms of lending.
Improved customer relationships: Factoring allows you to be flexible with your customer payment terms, because your payment comes from the factoring company the same day you sell the invoice. Also, the sometimes “hard” conversations about invoice payments are handled by the factoring company, which allows you to keep your focus on customer service and growth opportunities.
Disadvantages of Invoice Factoring
Cost: Factoring is not as affordable as traditional loans or lines of credit. However, if you are considering factoring, it’s probably because you have a need that is not being met by those forms of lending. Factoring is also typically more affordable than other forms of lending such as merchant cash advances (MCAs) that come with aggressive repayment plans. Lastly, factoring is more than just the access to funding. When you consider the additional services that are included in the fee, factoring looks even more favorable.
Unfavorable contract terms (depending on the company): There are many differences in the ways that companies can structure their factoring terms and fees. It’s important to have a good grasp on the agreement terms to avoid the feeling of being “locked in” to a contract. Here are some questions that can help you better understand what you’re signing up for:
What is the minimum term of the contract (i.e. 90 days, 6 months, 1 year)?
Is the factoring fee fixed or variable according to how long the invoice is outstanding?
Is there a fee when money is deposited into my account?
Is there a fee for each invoice submitted?
Is there a monthly minimum required?
Does the contract auto-renew? How long in advance do I have to give written notice if I want to stop factoring with the company?
Do I have to factor all of my Accounts Receivable or can I pick and choose which Accounts Receivable to factor?
Liability: If your customer fails to pay, then you may become liable for the invoice payment. This may sound a little daunting at first, but a good factoring company has tools at its disposal to help prevent this from occurring and will try to avoid this at all cost. However, if this does happen, then a good factoring company will work with you on a remedy, whether through a repayment plan or by replacing the unpaid invoice with future invoices.
Perceived lack of control of customer relationship: Most factoring companies will be involved in billing communication with your customers. For some companies, this may be a point of concern. When purchasing an invoice, good factoring companies will discuss these issues and any special needs regarding the account. And as we discussed in the section above, this may actually be a benefit, because it offloads your administrative tasks of following up on invoice collection.
How Much Does Factoring Cost?
Standard factoring rates are typically in the range of 1-5%. Why the range of pricing? It’s determined by several factors, such as:
Volume: The amount of invoices sold per month. For example, a company selling $100,000 of invoices per month would typically receive a better factoring rate than a a company selling $10,000 of invoices per month.
Average Invoice Price: Does your company sell a few large invoices per month or a lot of smaller invoices per month? There is an administrative cost to factoring companies to process a large number of invoices, so a company with a lower average invoice price may be subject to slightly higher factoring rates than a company that has a larger average invoice price.
Customer Payment Terms: It costs a factoring company money to have their money outstanding for a longer period of time, so shorter payment terms are rewarded with a lower factoring rate. For example, a company with NET30 payment terms would receive a lower factoring rate than a company with NET90 payment terms.
It’s also important to know whether your factoring rate is a fixed rate or a variable rate. Some factoring agreements will charge one flat factoring rate regardless of how long it takes for the invoice to be paid, so long as the invoice does not become delinquent. Other factoring agreements will charge a variable rate with lower rates for shorter repayment periods and higher rates for longer repayment periods. For example, you may receive X% if paid within the first X days plus X% for every X days afterward.
Beware of companies that advertise extremely low factoring rates. There is typically a catch that may come in the form of aggressive escalating rates, additional charges, long-term commitments, or monthly minimum requirements.
Is Invoice Factoring a Good Idea for My Company?
The fact is factoring can be a very good option for companies where there is a good fit, but it is not a one-size-fits-all approach for all companies. Here are some questions that can help you navigate whether factoring is a fit for your business:
Do you have business-to-business (B2B) or business-to-government (B2G) sales? Factoring is not an option for business-to-consumer (B2C) companies.
Do you rely on invoicing customers and do you have documents that show proof of delivery or fulfillment? Factoring companies will rely on these documents to verify billing with your customers.
Are your customers creditworthy? Factoring companies will approve or reject invoice purchases based on your customers’ creditworthiness. Want to find out if your customers would qualify? Get answers in a matter of minutes with a free consultation.
Do you have access to more affordable capital? If the answer is yes, then you’ll likely want to go in that direction. But if you’re struggling with finding more traditional forms of lending, then factoring may be a good option.
Conclusion
Invoice factoring is a useful financial tool for businesses. It helps with cash flow by turning accounts receivable into working capital, so businesses can cover expenses and invest in growth without waiting for customer payments. Factoring also saves time by taking on the task of collecting late payments, freeing up businesses to focus on their main activities. It's accessible to all types of businesses, including startups and those with less-than-perfect credit. It's flexible, allowing businesses to choose which invoices to factor. Overall, invoice factoring gives businesses immediate working capital, better cash flow management, and the ability to concentrate on growth and profits.
At Transwest Capital, we understand the challenges small businesses face when it comes to managing cash flow and maintaining a healthy bottom line. That's why we pride ourselves on being the preferred invoice factoring company for small businesses. With our quick and hassle-free approval process, we can provide immediate funding based on your outstanding invoices, enabling you to meet your financial obligations and seize growth opportunities. Our experienced team is dedicated to helping you succeed by reducing the administrative burden of collections and providing personalized customer service. Trust Transwest Capital for flexible financing solutions tailored to your unique business needs, and experience the peace of mind that comes with partnering with a reputable and trusted factoring company.