For any business, raising capital is a high priority. Finance is required to fund expansion projects, equipment purchases, and cover regular business expenses, to name a few applications. While raising capital is an important task at the best of times, it becomes crucial to businesses with late-paying clients. In such a circumstance, businesses can find their cash flow incredibly tight, making it difficult, or even outright impossible, to accurately plan for the future. This can put a stop to the growth of a business, as funds are stuck in its cash flow and cannot be used to expand.
For businesses in this situation, a method of finance exists to alleviate this problem, without the downsides of other traditional types of loans. This method is called invoice factoring. In this article, we will discuss this form of finance, how it works, and what benefits it has to offer your business. Let’s get started.
What is invoice factoring?
Invoice factoring is a method of raising capital that leverages your business’s unpaid invoices to get cash into your account. With invoice factoring, you will sell your unpaid invoices to an invoice factoring company, which will pay you the value of your invoices, minus fees. This allows a business to relieve its tightly constrained cash flow, freeing up funds to be used immediately, as opposed to being slowly drip-fed into the business over time.
How does invoice factoring work?
Invoice factoring has a fairly simple set of inner workings. As we mentioned, the process starts by selling your unpaid invoices, or accounts receivables, to an invoice factoring company. Assuming they are happy to make the purchase, they will pay you the total value of your unpaid invoices, minus interest and fees. In the end, you will probably end up with 95-97% of the overall value of your invoices, depending on your chosen invoice factoring company. Initially, you will be advanced a significant sum of your unpaid invoices’ value. This is usually anywhere from 80-100%, and is again heavily dependent on your chosen invoice factoring company. The percentage that remains, if any, will be paid to your business once your clients pay their invoices.
Also Read: Invoice Financing vs. Invoice Factoring
After the initial payment has been made out to your business, the collection process will begin. Unlike other, similar methods of raising capital, such as invoice discounting, your invoice factoring company will take on the collection responsibility. This company will contact your clients tied to the unpaid invoices you sold to them. The factoring company will collect what is owed, then send the appropriate amount to your business, after deducting fees for the service. Once all clients have paid their outstanding balance, and the appropriate funds have been made out to you, the process will end. This results in fast access to funds; instead of waiting until the end of a month for funds to become available, or sometimes beyond, you can receive capital in as little as a day.
If your clients do not pay their invoices upon the request of the invoice factoring company, you may be expected to reimburse them, essentially buying back the invoice from the factoring company. This isn’t a terribly common occurrence, as invoice factoring companies will not typically approve an agreement if they have concerns that clients won’t pay. Some invoice factoring companies have an additional fee should this situation arise, so keep this in mind while you consider your options.
Advantages of invoice factoring
Invoice factoring is a form of finance with several advantages. Here are some of the most noteworthy:
- Fast access to finance – Unlike many other forms of finance, invoice factoring has a very short turnaround. The application is short and streamlined, there isn’t a lot of paperwork and documentation required, and you’ll get your money quickly once your application is approved. After approval, you will receive your money in as little as 24 hours, with it going straight to your business account.
- Straightforward application process – Part of why invoice financing raises capital for businesses quickly is its application process. Compared to other forms of finance, invoice factoring has a much more streamlined application process than others. Factors such as proof of income, credit rating, financial history, and so on aren’t all that important with invoice factoring. Instead, the value of your unpaid invoices and the timeliness of your clients to pay them are paramount. If you’ve got unpaid invoices worth buying, an invoice factoring company will be happy to make a deal in short order.
- Not secured against collateral assets – Although invoice factoring is essentially a type of secured loan, it does not require the use of collateral assets. Instead, your unpaid invoices act as security; the invoice factoring company knows it can collect on the invoices to recover their money, and if your clients do not pay, most have stipulations that you have to buy back the invoice. This means much less risk for both you and the lender, and dramatically quickens the application process.
Disadvantages of invoice factoring
While invoice factoring does have a range of significant advantages, the process also has a few disadvantages that you should know before making a decision. Here are the most notable:
- No invoices, no loan – The most glaring disadvantage is that invoice factoring is situational. Business models that don’t use client invoices will not be able to use invoice factoring.
- Trading future profits for immediate cash – With invoice factoring, you are essentially discarding a part of your invoice revenue in exchange for receiving it immediately. While this can be useful for some businesses that require cash immediately, it is not a one-size-fits-all solution.
- Risk to client relations – Once you sell your unpaid invoices to a factoring company, it is their responsibility to make collections. Generally, this goes without a hitch; the company will contact the client, be professional and courteous while in communications, and collect what is owed for each invoice. However, some invoice factoring companies use more abrasive methods, which can damage your business’s relationship with a client. As control over payment collection is removed from your business, you should be very careful when deciding which invoice factoring company to use.
In summary
On balance, invoice factoring is a great tool for businesses with a tight cash flow, yet need funds quickly. This form of finance can free up money from a business’s cash flow in a very short space of time, owing to a quick and easy application process. It is also a fairly low-risk method of raising capital, making small businesses eligible without gambling their future. However, like any form of finance, invoice factoring isn’t perfect. You need an appropriate business model, and you will defer the responsibility for payment collection to an invoice factoring company. As such, it is important that you carefully curate which invoice factoring company you use, if any at all.