What is accounts receivable factoring?
With different types of businesses establishments coming up every day, the financing industry has not been left behind.
There are different financing options available for small businesses to access fast cash. Among these options is accounts receivable factoring. Also referred to as factoring financing or invoice factoring, accounts receivable factoring is whereby the company sells its unpaid invoices for a cash advance.
Many small business owners go for this financing option because they may not want to wait for 30, 60 or 90 days for customers to pay. This can be extremely helpful for businesses that need to fill a cash flow gap caused by slow paying customers.
It is also important to note that invoice factoring is not for every business. You should first find out if this financing option suits your business needs. However, it can be a good choice for businesses that want to infuse funds in the business without getting into more debt.
Here is a complete guide of how invoice factoring works and who this financial service is right for.
What you need to know about invoice factoring
Invoice factoring is a financial process whereby a business sells an invoice or a group of invoices to a financing company, known as the factor. In return, they receive an initial amount, which is a percentage of the invoice value (mostly between 70%-90%).
This initial amount is referred to as the advance rate. The remaining amount is forwarded when the customer pays their invoice, but it is usually less the factoring fee and other additional charges.
This can be a good option for business owners who want to be debt free since they will be receiving cash that they have already earned. Accounts receivable factoring can work well for different industries depending on their financial needs.
Since the factoring companies are more interested in the invoice value rather than personal credit scores or the business history, both startup and established businesses can easily access the funds. The services are mainly used by companies that sell consumer products.
In particular, this financing solution can be a smart move for;
- Companies that deal with clients who have long payment terms
- Companies that are short of working capital due to slow paying customers
- Companies manage fluctuating cash flows
- Companies that need cash to fund growth
- Companies that don’t qualify for a business loan
The invoice factoring process
Factoring transaction starts with the factoring company purchasing one or many outstanding customer invoices. The invoices have to be accurate, valid and should not be pledged as collateral to a different financing company. Once the invoices are verified, the company provides an advance rate of up to 90% of the invoice amount.
The rate can go up to 95% for other businesses including those in the transport industry. The amount is usually provided within 24 hours. This fast turnaround time is important in helping businesses pay bills on time.
The process of collecting invoices will also be delegated to the factoring company, and this will give you enough time to focus on more important issues concerning your business.
Once payment is received, the remaining percentage, less the fee charges which include a factoring fee that is typically 1% per week is forwarded. With this option, you will be able to take on new projects, purchase inventory, pay rent and employees on time and even expand the business, thanks to the fast approval process.
How to work well with a factoring company
One of the main risks involved in receivable factoring is fraud. If you want to avoid penalties and maintain a good relationship with an invoice factoring company, it is important to bear the following points in mind;
1. Do not factor invoices from customers with poor financial history
If you feel that the customer may delay the payment, or worse still may not be able to pay, then you may run the relationship with the factoring company. Also, if you decide on a recourse factor, you will have to pay both the invoice amount and extra fee charges if the customer does not pay the invoice.
2. Be open about what is happening
If you decide to factor an invoice and realize that the customer may pay late, it is better to inform the factor in advance. As much as this conversation may be tough, it will indicate to the factor that you are willing to pay and as much as late payment will attract additional charges, the factor is likely to listen to you.
3. Be keen on the factor’s notifications
If you work with a reputable factor, they may inform you if the customer is likely to make payments past the agreed upon time or when there is an issue with the bank that may hinder them from forwarding the rebate on time. Being attentive to such notifications will save you confusion and you will also prevent issues that come when you act in the last minute.
Benefits of invoice factoring
1. Fast access to cash
Accounts receivable financing has a fast approval process and you can receive initial funding within 24 hours. This is quite fast compared to bank loans that can take weeks to be approved.
2. Cash flow with no debt
Another benefit of invoice factoring is that you won’t commit yourself to long-term payments. Since factoring not a loan, it is not added to the liability side of your balance sheet. This eventually leads to a clean balance sheet at the end of the financial year.
3. Affordable factoring fees
The factoring cost has drastically reduced over the years and advance rates can be offered up to 95% depending on your industry and the customer’s financial history, how long it takes for payment to be made among other considerations. The rate can also be as slow as 1.5%
4. No strong financial history requirement
To qualify for funding, you don’t need to have good credit or generate specified annual revenue. Invoice factoring companies only look at the creditworthiness of your customers(s) and the invoice value. This is good news to startups and businesses with poor financial backgrounds.
5. Reduces workload
Once you factor invoices, the responsibility of collecting payments remains in the hands of the factoring company. You will then have enough time to deal with more crucial areas of the business. Since you won’t be the one collecting the payment, you won’t have conflicts with your customers and this also enhances your relationship.
Even with all the benefits that come with a factoring loan, this option also has its drawbacks. This is especially on the costs involved. Some people have the assumption that invoice factoring costs more compared to bank loans and other traditional lending options.
As a result, most business owners who contact factoring companies are perceived to be failing financial or have poor credit. But this claim may also not be true since even successful companies use invoice factoring when they need cash to fund their short-term needs.
How much does invoice factoring cost
Among the things that most businesses would be interested in is the cost of factoring services. This is actually understandable since you don’t have to pay extremely high fee charges just to access short-term funding for your business.
Luckily, invoice factoring does not come with outrageous charges. Receivable factoring companies usually charge a factoring fee for the services provided. There are also other companies that may have additional charges too.
The fees paid depend on several factors which includes;
- The type of industry you are in
- Your customers’ creditworthiness
- The volume of invoices to be factored
- The factoring agreement terms
- The time taken for the customer to pay
If you choose nonrecourse factoring, the rate will be higher since the factor bears all the risk. This rate is usually lower for recourse factoring. In most cases, factoring companies charge between 1% and 4% for 30 days.
Other companies can also charge an application fee, bank transfer fees, collateral and other costs that are usually deducted from the outstanding amount.
Invoice factoring is an easy way for companies accessing cash for working capital rather than waiting for weeks to receive payment from customers.
The company is provided with a cash advance, which is a percentage of the invoice amount to help minimize a cash flow gap caused by slow payments. Since this service involves collection of accounts receivable, it is at times referred to as accounts receivable financing.
To ensure that you work with the best factoring company, you first have to know what your business needs are and it is also important to ask the right questions. Additionally, you should be careful of hidden fees and getting locked into long-term contracts.