Why wait for payment when invoice factoring can get you the cash?
For a small business owner, the availability of cash to run operations is vital. Owners must seek ways to strengthen their cash flow. Invoice factoring services come as a highly recommended approach. It involves selling your invoices to a factor, usually a third party such as a bank or other agencies. The sale is at a discount rate. Unlike other forms of business financing where you offer the lender some collateral, in factoring you sell all or a portion of your accounts receivables. In the end, you obtain cash sooner than it would have taken to convert invoices to money.
How does factoring work?
Once an invoice factoring company takes over your receivables portfolio, you can now focus all your energy elsewhere. The task of debt collection goes to another person giving you sufficient time to run your business. Meanwhile, your business gets the much-needed cash to restock, pay suppliers, utilities and other operating costs. Here is how accounts receivable factoring works:
After completing a sale or service delivery, you send an invoice to your customer. However, you must attach a sticker or add a note on the document informing customers that one of the invoice factoring companies will do the collection.
You then collect copies of all invoices dispatched and send them to your factor. Depending on the agreement, you can submit the sale documents on a value or size basis. Another approach you can use is to have the invoices sent on a weekly basis.
Upon receipt, the factor pays a portion of the total invoice value. Some do pay up to 90 percent at an agreed date or on dispatch.
The task of issuing statements to clients, chasing for, and collecting payment becomes the factor’s responsibility. However, you can agree on the methods that would work to the benefit of both parties.
Once the customers pay what is outstanding on their invoices, the factor pays you but deducts their charges. The factoring rates consist of a cost for the work involved plus some interest on the advance payment you received earlier.
Who needs invoice factoring?
If your business requires a consistent cash flow, you may consider invoice factoring. However, once you choose this path, get ready for what will follow. You will be introducing a partner to your business. In other words, you cede control of your sales ledger to another person. Your factor should have all the contact details for your customers plus their history. There is no room for secrecy.
Before consenting to your request, an invoice financing company will examine and require that you meet some conditions. First, your customers’ credit scores must be of good standing. Besides, the businesses you deal with must have been operational for some years. Factors are a bit hesitant when dealing with start-ups. At the same time, customers you invoice should be in the business to government (B2G) or business to business (B2B) categories. In case a factor doubts the likelihood of your customers paying their invoices, they will not take over the debt.
Second, the invoices you want to convert to cash must be 90 days and below. Also, you must not have used the same to secure another short-term loan. Funding takes anything from two days to a week. During this time, the financing company carries out background checks and ascertains whether you are worthy of getting the funding.
Third, your business reputation should be of good standing. At any hint of legal or tax problems, a prospective factor will drop off at the negotiation phase. Once you get clearance, you receive the funds, which can take a day or two to come through. Some financing companies have no paperwork and handle every process electronically.
Factoring with recourse
If some of your customers did not pay on time, a financing agent will encounter the same problem. However, if you enter into a recourse factor arrangement, the financier will ask you to pay what the customer has defaulted. Imagine what would happen if you had already committed the funds you had obtained from the factor. To avoid such an occurrence, choose invoices from customers with whom you have a had a history of the prompt settlement of their account.
On the flipside, you can still sign a non-recourse agreement. When this happens, the financing agency agrees to foot the risk of customers who do not pay on time. You should be careful and read the contract carefully as some firms give conditions for no recourse. In other instances, the deal will offer you a partial solution. Always go for firms that do not hold you accountable for late or non-payment of invoices.
Spot and contract factoring
In spot factoring, you sell only one outstanding invoice to a financing company. The idea sounds good since you maintain control of your sales ledger and do not allow too much outside interference. Unfortunately, factoring agencies do not like the approach. They consider it as not being cost effective since the process of factoring a single invoice is no different from taking charge of all. Besides, they will earn very little from that task.
Contract factoring, on the other hand, involves giving away a specific value of the invoices, preferably monthly. Other factoring companies will require that you place all invoices for the selected customers under their care. Monthly volumes can begin from a threshold of $10,000 worth of sales going upwards.
Despite the differences in these two financing options, you must be open to the terms you have offered to your customers. In that case, spot factoring can be an ideal option. Look for a funding agency that allows you to choose the invoices you want to be factored as compared to adopting a blanket approach.
Mitigating for bad debts
Recall that for non-recourse factoring, the financing firm takes care of the invoice amount including the risk of bad debts. Another conventional arrangement is where the factor pays you less out of all unpaid invoices. The amount hived off goes to cater for a debt whose collection is in doubt or has gone bad altogether. Other than the element of obligations going bad, your business running costs reduce. Now that you have outsourced revenue management work, you no longer must hire debt collectors or credit control staff. All human resources available in your business shifts focus from debt collection and turns their attention to production, service delivery and production of goods.
Qualifying requirements summarized:
- Factoring is mostly for businesses with a corporate structure. Some companies buy invoices from other forms of enterprises such as partnerships and sole proprietorships.
- Your customers must be from the government or commercial sector. The entities that buy from you must either be government entities or companies.
- Your clients should have good credit status. Customers in question are those that are most likely to pay when all other factors remain constant.
- The invoices you select for factoring financing must not have other commitments. For instance, you cannot use what you have given as collateral for a bank loan as an item to obtain a factoring loan.
To sum up
When you decide to use accounts receivable financing as a mode of increasing your cash flow, you practically “sell” the accounts receivables and get an immediate cash advance in return. To achieve this objective, you approach a factor who will carry out their checks and consent to the arrangement. As the process gains momentum, the financing company requests that you tell them how much you need. After that, you identify the customers whose invoices you want to factor.
Meanwhile, you continue to render your services or deliver products as was the case before. Each time you complete a sale, you send your invoices to the factor. Upon verification, they wire the money into your bank account. On their part, they deal with the customer as if it were you talking to them.