There are different types of financing that you can obtain as a business owner. The most popular are a line of credit or a business loan. Which will work better for you will mostly depend on what it...
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Invoice factoring lets businesses capitalize on their outstanding invoices by using them as collateral to receive an immediate injection of financing from a short-term loan by a top business loan provider. Businesses typically use this strategy in batches each month, so that customers who pay late do not upset the business’s day-to-day operations. In this case, the lender is known as the “factor”, and they purchase a business’ invoices in exchange for capital, which is repaid to the factor once customers pay their outstanding invoices.
In return for providing these services, factors take a fee based on the amount of financing provided and the duration of repayment. The factor relies on the reputation and credit of the company’s customers, the volume of incoming invoices and their amounts, as well as other characteristics including industry and market stability when determining appropriate rates for this service.
A lack of working capital can be a tough obstacle to overcome, however, companies with a steady stream of invoices can use them as leverage for accessing the cash they need immediately. Running a growing business costs a significant sum, and in the short-term, overhead costs can significantly outpace revenues in certain cases. A company’s day-to-day operations and liquidity can be seriously hampered by clients who pay on delayed schedules or after work has been completed. Invoice factoring is designed to offset these obstacles, helping businesses manage cash shortfalls by providing immediate funding.
Companies prefer invoice factoring because it offers improved cash flow, scalability with sales, flexible terms and low fees. It is also not considered a loan, and therefore keeps the books much cleaner than alternative options, such as invoice financing. For business owners who need their invoices’ value immediately, invoice factoring can prove to be a solid alternative.
When a factor buys a business’s unpaid invoices, they are taking a risk. While most customer invoices are likely to be paid—especially the high-credit customers that most factors will do business with—they cannot be guaranteed. Accordingly, the factor will release funds in two stages – once when the invoice is received and once more after it is paid by the customer.
The Invoice: Invoices are receipts from a business to customers informing them of the amount owed for the goods or services purchased by the customer. Factors are willing to work on good faith with invoices for customers that have good credit and a strong payment history, giving invoices real monetary value. There are some restrictions, such as factors only allowing invoices that come from high-credit customers, and from those that pay on schedules between 30 and 90 days after invoicing. Many factors also require that a minimum dollar sum of invoices be factored each month.
The Advance Rate: This is the percentage of the invoice total that the business receives up front from the factor. This is usually between 80.0% and 95.0%, but can reach as high as 98.0%. Advance rates can be higher when the invoices are from higher-credit customers, or when volumes are lower. Factors also consider the size of the invoices, the industry the business operates in, and the financial stability of both the business and their customers.
The Discount Rate: After the invoice that the factor bought is paid, the factor releases the rest of the payment that was not included in the advance rate minus a discount rate, which is usually low. This is essentially the small fee that the business is paying for the advancement of their outstanding invoices as cash. How long an invoice goes unpaid also affects its factoring value, as the discount rate can range from 0.5% to 5.0% per week or month, depending on the factor.
Best in the Industry: The first step to finding the right invoice factor is to focus on those companies that operate in the business’ industry. Although there are several factors available today, many work with specific sectors such as energy, transportation, manufacturing, or wholesaling. Once companies find a list of the industry’s best available factors, they should move on towards considering their own customers and invoices.
Invoice Length With Discount Rate: An important consideration for businesses is how long their customers take to pay outstanding invoices. For those businesses with customers paying invoices on the longer end of the duration spectrum—closer to 90 days—they may be better served finding a factor that only charges a single fee, as opposed to the monthly charges some lenders offer. Businesses should always look for the factors with the lowest fees and highest advance rates to receive the best available financing terms.
Get a Big Advance Rate: To make the most out of their invoices, businesses should always seek those factors that offer the highest factor rates. However, companies should beware of high advance rates that are accompanied by heavy discount rates and fees.
Additional Fees: For smaller invoices, fees might eat up a significant fraction of the total amount receivable. In some cases, factors charge up to $15 per invoice, while some include other fees such as origination or other hidden transactional fees. If not careful, customers can lose a substantial portion of their invoices to additional charges. Companies should always read the fine print and find transparent factors that are open about their fee structure.
Faster is Flexible: While the differences between factors are generally negligible, some may provide funding in as many as 3 business days while others may deliver the business’s advance rate the same day. Depending on how quickly the cash is needed, finding a factor that offers same day disbursement might be an important consideration.
Minimum Factor Amount: Can the business fulfill the minimum monthly factor amount required? Some companies require a minimum of $30,000 to $50,000 to offer factoring, so those without consistent billing in this range should steer clear or risk the accumulation of extra fees at the end of the month.
Bad Contract Comprehension: Business owners should make sure to read the contract very thoroughly before entering an invoice factoring agreement. Loan agreements are highly specific, including information about fees, procedures, payment schedules, and more. Once agreed upon and signed, these contracts can be difficult to amend. Companies should always guarantee they understand all the terms and conditions before putting a pen to paper.
Slow Customers: In some cases, one should avoid factoring the invoices of their slowest customers, as it may erode the total received after discounting. Some factors include a sizable discount rate for delayed payment, significantly lowering the amount a business receives per invoice.
Getting Denied: As with most forms of financing, applying for invoice factoring can hurt a business-owner’s credit, as they generally require hard credit inquiries. Before getting started, companies should be thorough when making sure they fit the minimum criteria for factoring solutions. Additionally, they should understand the application process to help avoid any complications that could result in a rejection.
For certain purposes, invoice factoring is one of the ways a business can finance itself by gaining access to their unpaid customer invoices as instant cash by paying a small fee. While there is much to consider, those looking at invoice factoring as a potential solution for their business would be smart to start researching the available options now.