What is factoring? Find the best short-term financing options for your business
At times, it may be difficult to manage a business if you do not have enough cash flow due to slow-paying clients. Clients taking long to pay also comes with a number of issues – employees won’t be paid on time, your rent will be delayed and you may have to turn down an important client due to insufficient funds to take up a new project.
Luckily, there are several small business funding options you can consider, and among them is invoice factoring. With this form of financing (also known as receivable financing) you can easily convert your outstanding customers’ invoices into immediate cash to cover short-term business expenses.
Basically, invoice factoring is a transaction in which small business owners sell their invoices to a lending company, referred to as a factor. The factor then collects the invoice payment from customers. One benefit of factoring is that you can easily access funds to fill a cash flow gap caused by slow paying customers.
So what is factoring and is it a smart move for your business?
Taking a closer look at invoice factoring
The factoring business has been around for decades. Unfortunately, very few companies are aware of this lending option.
With invoice factoring, the factor provides a percentage of the invoice value (this is mostly between 70% and 90%). This initial amount is known as the cash advance rate. The rate can vary depending on the factoring company, the customers’ credit history and the industry you are in.
The funds are usually provided within 24 hours. The remaining amount, known as a rebate, minus a factoring fee and other additional charges will then be forwarded once the customer pays.
Why you shouldn’t wait for 30, 60 or 90 days for customers to pay
Waiting for payment from customers will reduce the amount of cash flow your business has to meet immediate expenses and achieve long-term business goals. There are many benefits that come with a factoring loan, the main one is that you will receive immediate cash to run the business. Other benefits of factoring financing include;
The responsibility of invoice collection will be delegated to the factoring company. You will then have enough time to run the business operations.
Invoice factoring companies consider your customers’ creditworthiness when advancing money and not your personal or business history.
Since this is not a loan, you won’t have to worry about paying back the money over the years
What type of companies factors invoices?
There are many finance providers that offer invoice discounting services. This makes the rates, fees charges and the terms and conditions of factoring very competitive.
To find the best company to work with, it is important to consider the number of years they have been in operation, whether they are familiar with your industry and if they provide flexible funding options.
How much does it cost?
Factors have varied fee charges. There are some that only charge a factoring fee depending on the creditworthiness of your customers while others have additional fees for shipping, collateral and money transfers.
It is advisable that you pay attention to the fee structure of different factoring companies. Ensure that the factor is clear with the fees they charge and you should also go through the terms and conditions of the contract. Most of these contracts end after one year, after which they can be renewed.
Recourse and nonrecourse factoring
When choosing invoice factoring, there are two options that you can consider – recourse and nonrecourse financing. Recourse factoring is whereby the business sells its customers invoices to a factoring company with a promise to buy back any uncollected invoices.
With this option, there is no credit risks involved for the factoring company, which makes it a popular option among factors. With nonrecourse factoring, the business sells the customers invoices to the factoring company to get the cash their need to run the business. Here, the factor bears all the risks and in turn, they increase the factoring fee.
Both options have their own benefits and drawbacks. For instance, recourse factoring has low transaction costs, but if the customer refuses to pay, it is the business that will be responsible.
With nonrecourse factoring, the risk is transferred to the factor, but it also has high transaction costs. Before choosing the best option, you should first evaluate the invoice value and the creditworthiness of your customers. If the factoring amount is quite small, you may decide on recourse factoring since it is a more affordable choice. Some factors provide both options for their clients.
Finding the best factoring company
With so many invoice factoring companies available, finding the best option can at times be overwhelming. What looks like a good choice at first glance can turn out to be disappointing.
If you consider invoice factoring as the best funding option for your business, there are some important considerations that you have to bear in mind. This includes the contract terms, extra fees, flexibility and whether the company has experience working with your industry.
When it comes to the invoice factoring cost, it is important to read the fine print. Factoring clients should especially pay close attention to the fees, advance rate, and any other additional charges. This is because what may seem to be a cheaper option at times can turn out to be expensive due to additional charges.
If you need to factor invoices on a seasonal basis, then there is no need of signing long-term contracts. There are plenty of companies that provide month to months agreements with fewer requirements.
You also should decide which of the two factoring options-recourse or nonrecourse factoring will work well for your business.
In order to get the best services, finding a factor that has experience in financing businesses like yours can be a good option. As much as all factoring companies provide small business financing, some offer additional benefits depending on the industry they specialize in.
Apart from the industry experience, the factoring provider should be reputable and have a proven track record of success.
The difference between factoring and bank invoice loan
Invoice factoring and bank loans are both forms of securing cash to meet your business needs. But there are also differences between factoring and bank loans or line of credit. First, factoring is not a loan.
This is because you will be borrowing money that you already have. The only problem you have is delayed payments from customers. Your obligation to the factoring company ends once the customer pays.
But with bank loans, you have to pay the principal amount plus the interest rate over a certain period of time. Some bank loans have a term of up to 10 years, which means that it can take much time for you to be debt free again. Early payments may also attract prepayment penalties.
Secondly, bank loans come with strict requirements. For you to qualify for the loan, you need to have a good credit score, provide collateral and generate high annual revenues.
When it comes to invoice factoring, you can easily access funds whether you have good or poor credit. Most invoice factoring companies consider your invoices value rather than your personal or business credit history.
With invoice factoring, you can access business funds as soon as 24 hours. There is also minimal paperwork required. This is contrary to bank business loans which require a lot of documentation and it can take weeks or even months for your business to be funded.
Not all small business financing works well for business owners. With factoring financing, you can easily build up your cash flow while waiting for clients to pay.
The question on whether invoice factoring is right for your business depends on the business needs and the creditworthiness of your customers. If you need quick funding and your customers are reliable, then this can be the best option for you. You should also ensure that you can afford the fee charges that come with invoice factoring.