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How to Use Invoice Factoring to Finance Your Business
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Cash is essentially the bloodline of any business, it’s needed to pay employees, bills, rent, daily expenses, Etc. All which need to be covered or you may be unable to produce the goods and services your business specializes in. After all, you need to spend money to make money.
Most businesses will incur financial issues at some point. There are many solutions to improve cash flow, one of which is invoice factoring. To learn more about what invoice factoring is and how you can use it to improve cash flow in your business, continue reading below.
Invoice Factoring Explained
Invoice factoring is the process of a business selling their invoices to a third party, known as a factor or factoring company, at a lower amount in exchange for cash. Common factoring companies include banks, financial institutions, or private factors. Invoice factoring is useful for businesses whose customers don’t pay for goods or services immediately, but ample cash is needed to operate the business.
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How Does Invoice Factoring Work?
Invoice factoring can be described in five distinct steps:
- A business provides goods or services to a client on account meaning that the money for the goods and services is not due until a later date. The amount owed for the goods and services is invoiced to the client and the due date is defined on the invoice.
- The business’ invoices are sold to a factoring company in exchange for cash through an agreement. Finding a factoring company is not always easy, you will need to go through an application process and meet certain criteria. In addition, there is usually a maximum amount the business can borrow which is set in the agreement. At this point, the factoring company becomes heavily involved in the accounts receivable process of your business.
- After invoices are submitted to the factoring company, they will give you a cash advance. The extended amount of cash is typically between 70% and 85% of the total invoice amount. The factoring company may send out a “notice of assignment” to clients or ask you to do so. The notice will state that the invoices have been assigned to a factor and payments will go to a specific account set up by the factor.
- The factoring company will get paid whenever money is collected from the customer. Depending on your industry and invoice terms, this will be between 30 and 90 days. The collection of amounts due is typically done by the factoring company, not the business. Factoring companies do their best to maintain business practices to ensure that clients are not harmed.
- Once invoice amounts are collected, the factor will give the business the remaining amount less their fees. Factoring companies don’t express their fee in terms of an APR, instead, it is expressed in an advance rate (the percentage of invoices they’ll extend) and the monthly factor rate. You can determine how much you’ll receive by using the following formula: 100% – advance rate – monthly factor rate. For example, if your advance rate is 75% and the monthly factor rate is 5%, you would receive 20% (100% – 75% – 5%) of the invoice total.
Keep in mind that invoice factoring is not technically a loan, it is merely an agreement that the payment of an invoice will go to a third party instead of the business in exchange for cash.
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Why Should You Use Invoice Factoring?
Invoice factoring is a common solution for companies experiencing cash flow issues. This could be increasing cash flow for some specific purpose or to get cash immediately. More often than not, invoice factoring is a short term solution, but this also depends on the industry.
Another benefit of using invoice factoring is that it is not a traditional loan. This means you don’t need to go through a rigorous approval process like you would with a bank or other lender and no collateral is required. Using invoice factoring is a good solution for companies aiming to avoid traditional business loans.
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Disadvantages of Invoice Factoring
The main disadvantage of invoice factoring is the expensive fees which would be entirely avoided if you waited to be paid by your customers directly. Although, the fee is simply the cost of getting money now instead of later.
Other disadvantages of invoice factoring include loss of direct control with customers and bad debts could derail your financing arrangement. Invoice factoring might not always be fair to customers which is something to consider before you proceed. Also, if your customers have poor credit, this could derail your application process since factoring companies consider customers’ creditworthiness. Furthermore, if customers don’t pay, the business may need to buy back the invoice or replace it with one of equal or higher value.
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Does Your Business Qualify for Invoice Factoring?
In order to qualify for invoice factoring, you will need to meet the requirements of the factoring company. Common requirements for invoice factoring include:
- Invoice payable within 90 days, or another specified period of time
- Operate a business, sometimes for a minimum period of business operation is a requirement
- No liens or limitations on invoices
- Profit margins
- Amount of cash required
- Credit history, taxation, and legal issues
- Customer creditworthiness
- Commercial or government clients
- No bankruptcy
- Good personal credit and background is a plus
What If My Customers Don’t Pay Their Invoices?
If your customers don’t pay their invoices, the issue will be handled according to what is outlined in the agreement with the factoring company. Usually, there will be a clause on a recourse or non-recourse factoring.
Recourse factoring is when the factoring company can take payment from the business if the customer does not or cannot pay off their invoice within an appropriate time period after the due date. On the other hand, non-recourse factoring is when the factoring company is responsible for the customer not paying and therefore takes on that risk.
Recourse factoring can really hurt your cash flow if you already spent money earned from the factoring contract. In addition, if your customers don’t regularly pay on time, there is a greater risk associated with recourse factoring.
Non-recourse factoring is obviously more favourable to the business, but many factoring companies may not want to take on this risk. Also, if a factoring company offers this to you, be sure to read the fine print because there can be additional conditions as to when non-recourse and recourse factoring applies.
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Do I Have to Factor All of My Invoices?
Again, the answer to this question depends on the contract you’ve entered into with the factoring company. In your contract, the terms will be either spot factoring or contract factoring. In short, no, you don’t have to factor all your invoices, but you might not get the liberty to choose every invoice that gets factored.
Spot factoring is when the business can sell individual invoices to the factoring company. On the contrary, contract factoring requires a set amount be factored each month or that every invoice from a specific customer is factored. Contract factoring is much more common than spot factoring, but the application process and underwriting are not significantly different.
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What is the Difference Between Invoice Factoring and Invoice Financing?
Invoice financing involves using invoices as collateral to obtain a cash advance as opposed to selling the invoices. The business then repays the lender according to the agreement regardless of when money from invoices is actually collected. The business remains responsible for collecting the debts instead of the lender. In fact, this is the main distinction between invoice factoring and invoice financing, the control of the invoices remains with the business instead of being transferred. Invoice financing is more favourable to businesses that want to maintain control over their customers and accounts receivable processes.
Is Invoice Factoring Right For You?
Whether or not you choose invoice factoring to improve your cash flow depends on your business and unique preferences. Invoice factoring is extremely popular for some industries, such as the shipping industry, but not common in others. Furthermore, how you handle cash flow problems and deal with clients can impact your decision to use invoice factoring. Be sure to consider your company’s unique needs and goals to determine if invoice factoring is the best solution for your needs.
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