When should you consider factoring financing?
One of the most frustrating moments in business is when you are waiting for customer payments. All types of businesses, whether they’re small enterprises or large corporations, can run into cash flow problems when customers extend their payment terms.
Most customers demand a longer time to pay simply because they may not afford payment at the moment. Many small business owners use factoring financing to maintain a steady cash flow without taking a new debt or selling equity.
With this form of financing, also referred to as invoice factoring or accounts receivable financing, you can easily access cash to meet your short-term business needs. So what exactly is invoice factoring, how does it work and is it the best option for your business?
This article will help you understand how invoice factoring works, circumstances when you can use this business financing option and whether it is an affordable choice for your business.
So what is invoice factoring?
The factoring industry has been around for decades. It is mostly used by small business owners who want to cover a cash flow gap caused by slow paying customers.
With this financing service, you can easily get funds for working capital rather than waiting for 30, 60 or 90 days for customers to pay their invoices. This process invoices selling your unpaid invoices to a factoring firm.
If you do not have enough cash to run the business, you may miss out of expansion opportunities, your employees may be paid late and you may also have issues with suppliers. Luckily, invoice financing can eliminate this problem by helping you manage the business without any financial mishaps.
The factoring transaction usually involves 3 parties:
- The company that issued the invoice
- The customer (or accounts debtor)
- The financing company (known as a factor)
How invoice factoring works
Once the business delivers a product to their client, an invoice is sent. If it takes a longer period for the customer to pay their invoice, the business can decide to sell this invoice to a factoring company.
In exchange, the company provides an advance amount, which mostly falls between 70-90% of the invoice value. With the funds, you will be able to pay employees on time, purchase supplies and take on a new project. Once the customer pays, the remaining percentage (called a rebate) is forwarded less the factoring fee that is usually based on the invoice value and the time taken for the customer to pay the outstanding invoice.
Eventually, all the 3 parties involved in the factoring transaction will benefit-the customer will have enough time to clear the invoice, the factor earns a fee for the services offered and the business will have immediate cash to meet short-term needs.
The difference between invoice factoring and traditional bank financing
Compared to loans from banks and other alternative lenders, invoice financing is not a debt. A business sells its invoices, gets cash in advance and waits for payment from customers to complete the transaction. Besides, factors do not have restrictions on how the funds should be used.
Another advantage of invoice factoring is that financing companies only consider the customer’s creditworthiness and not your personal credit or business history. This makes it easier for startups with no credit history to qualify for funding. Besides, you can also access the loan if you have poor credit score.
Lastly, invoice factoring has a simple and more straightforward application process. The paperwork involved is also minimal compared to traditional bank loans. In fact, some factoring providers offer a complete online experience with no paperwork required. You can also qualify for higher amounts compared to other lending options.
How much does factoring cost?
Invoice factoring providers charge a fee ranging from 1% to 5% of the invoice value per 3o days. When shopping for a company with affordable rates, transparency is also crucial. Some of the companies may not be transparent in the way they calculate their fee, which is usually for their own benefit.
In such a case, it is better to find a factor with more transparent rates. Again there are also companies that advertise very low factoring rates, but if you are not careful, you may be hit with other hidden costs.
How can invoice factoring improve your business?
Most small business owners prefer invoice financing to bank loan applications and merchant cash advances. This is because it involves a lower risk because the sales are already made and invoice confirmed.
What remains is the customer to pay the invoice and the transaction will be complete. So long as you are sure that the customer will pay on time, you don’t have to worry about committing yourself to long-term contracts.
When it comes to bank loans, this is actually the opposite. The loan will require you to pay both the principal and interest over a certain period of time until the payment is complete. This can at times be stressful for small business owners considering that they have to pay the loan interest and meet their immediate needs like making payrolls and purchase supplies at the same time.
With no debt to pay and factoring cash in hand, you will be well prepared to take your business to the next level.
How can you qualify for invoice factoring?
Luckily, qualifying for factoring financing is easy. While you need to have good credit score, operate a profitable business and generate a specified amount of annual revenue to qualify for a bank loan, this is not the case with factoring.
There are only 3 things that factoring companies consider to have the funds approved;
- The creditworthiness of your customer
- The value of invoices to be factored
- The time taken for the customer to pay
Finding the best invoice factoring companies
If you feel that your business can benefit from a factoring loan, which it obviously will, you will now be faced with an important task of finding the best factoring company. There are quite a number of factoring providers out there, so how will you know that you are working with the right guys?
Choosing the best company should not be done in a hurry. You obviously would want to find a factor that not only provides funding but also knows your business needs and can work with you to ensure that those needs are met. Besides providing the funds, they should also be your business partners.
It is also important that you work with a company that has experience working with your industry. In this case, you can be guaranteed fast approval and affordable factoring fees.
Invoice factoring is among the short-term financial options that businesses tend to overlook, but if you are in the industry of manufacturing, distribution, mining, oil, and gas, you may be having a number of invoices that can easily be turned into cash.
To manage their invoices, most businesses have an accounts receivable department. You can tell when it is time to consider invoice factoring when your business needs instant funding, your invoices are sitting stagnant, or it is difficult for you to qualify for a bank loan due to the tight requirements.
In this case, you can easily get the funds you need to meet both short-term and long-term financial goals.