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aving healthy cash flow is essential to running your business smoothly. To help solve cash flow challenges, consider invoice factoring, a financial solution that helps businesses get immediate access to cash by selling unpaid invoices to a third-party factoring company.
While invoice factoring can be a good solution if your business needs fast access to funds, it’s crucial to understand how invoice factoring works before pursuing this type of financing.
What is invoice factoring?
Invoice factoring involves selling your business’s unpaid invoices to a third party, known as a factor or a factoring company, for the total amount owed minus a factoring fee (typically 1% to 5% of an invoice’s value). After the factoring company purchases your outstanding receivables and pays you an advance, it will be responsible for collecting payment from customers. Only companies that invoice customers (i.e., B2B businesses) qualify for invoice factoring.
In total, you’ll receive up to 95% of an invoice’s value from the factoring company, which can be used to cover expenses or invest in growth opportunities.
How does invoice factoring work?
The process for invoice factoring is relatively straightforward. The steps are:
- Submitting an application with a factoring company: When applying, the factor will likely require information about your business financials, credit history, and customer invoice details. The factoring company will review your application and assess the creditworthiness of your business and its clients.
- Approval and invoice submission: If approved, the factoring company will outline a financing agreement, which covers the advance amount, the factoring fee, and the date for the remainder to be paid. If they approve the invoices, they’ll pay out an advance – usually up to 90% of your invoice amount – and begin to work on collecting payment.
- Payment collection: The factoring company will work to collect payment from customers. Once a customer pay, the factor deducts its factoring fee (usually 1-5%) and pays you the remaining amount owed.
Note that the factoring company may not approve all invoices. In most cases, invoices already past due or with payment terms for more than 90 days don’t qualify. Other eligibility criteria may include your customers and their credit ratings, as well as issues that could affect payment, such as your accounts payable performance or any outstanding lawsuits.
You may also need to agree to a “recourse” provision, where you commit to returning some or all of the advance if the customer invoice ends up not being paid. If there isn’t such a provision, the factoring company may charge you a higher fee.
What are the benefits and drawbacks of invoice factoring?
There are a number of pros and cons of invoice factoring. Here are a few:
Pros of invoice factoring
- Ability to boost cash flow quickly: Businesses usually receive a large portion of their outstanding invoice amounts within a few business days. Invoice factoring is especially useful for those who need a quick injection of cash to keep operations running smoothly or to capitalize on an opportunity. You can offer your customers longer payment terms and still get paid quickly.
- May be easier to get approval compared to traditional funding sources: Traditional business loans may have more eligibility criteria and take longer to get approved for. This is especially true if your credit isn’t great, if you don’t have collateral, or if you haven’t been in business for very long. Factoring companies typically care less about those things and more about your outstanding invoice value and whether your customers are creditworthy.
- Unsecured financing: Invoice factoring is a form of unsecured financing, meaning that the factoring company doesn’t require collateral and can’t seize any assets in the event of non-payment.
Cons of invoice factoring
- Costliness: Traditional loans are assessed based on the borrower's risk level, and therefore interest rates may be lower for owners with excellent credit. However, factoring companies look at your customer's credit. That means if there is a high risk of non-payment, your fees could be higher than what you may qualify for with traditional loans. There’s also the possibility of additional fees, including application and processing fees, late payment fees, returned check fees, wire transfer fees, and recourse fees.
- Less control: Once you sell your invoices, the factoring company will work to collect the amount owed. You’ll need to ensure that the company you choose interacts with your customers appropriately.
- Limited eligibility: Because invoice factoring relies on the use of invoices to collect payment, this funding method doesn’t work for businesses that sell directly to consumers.
- No guarantees: It’s possible that your factoring company is unable to collect on your outstanding invoices. If you’ve agreed to a recourse provision, you may have to repurchase the invoice or provide another one of equal value. With non-recourse factoring companies, you’re not on the hook for unpaid invoices, but fees are typically higher because of the added risk.
Invoice factoring versus invoice financing: what’s the difference?
While both invoice factoring and invoice financing are used to boost cash flow, there are some key differences. Namely, with invoice factoring, the factoring company is responsible for collecting the amounts owed. With invoice financing, however, your business is responsible for collecting what’s due. Instead of buying your invoices, invoice financing companies use the invoices as collateral in exchange for a cash advance.
Both invoice financing and invoice factoring companies charge fees (typically based on invoice value), are relatively quick to fund, and are limited to businesses that invoice customers.
How to qualify for invoice factoring
Though factoring companies will have their own qualifying criteria, here are a few general eligibility criteria for invoice factoring:
- You have a formalized business, like an LLC or a corporation
- Your business has commercial or government clients
- The factoring company can look up your client's commercial credit history
- Your business has a certain amount of profit margins
- There are no liens or encumbrances for your business or invoices
Novo Platform Inc. strives to provide accurate information but cannot guarantee that this content is correct, complete, or up-to-date. This page is for informational purposes only and is not financial or legal advice nor an endorsement of any third-party products or services. All products and services are presented without warranty. Novo Platform Inc. does not provide any financial or legal advice, and you should consult your own financial, legal, or tax advisors.