What is factoring receivables and how does it work?
Factoring receivables is a financial option that allows business owners to convert their outstanding invoices into immediate cash. The invoice company usually provides the funds in two installments.
First, the factoring company provides an advance rate, normally between 70% and 90% of the total invoice value. The remaining percentage, less the factoring fee is issued once the customer pays.
In exchange for selling the outstanding invoice, you can easily access cash to minimize a cash flow gap caused by customers who take longer to pay. Rather than waiting for a customer to pay, the financing option offers short-term solutions to meet immediate business needs.
Compared to bank loans, invoice factoring, also known as accounts receivable financing is not a loan. Your obligation to the factoring provider ends once the customer pays, meaning that you won’t have to commit yourself to long-term contracts like the traditional financing options.
Besides, it has an easier application process and you can access funds in as little as one business day, thanks to the faster approval process.
How invoice factoring works
Factoring transaction is used by small business owners to solve cash flow problems. The unpaid customer invoices are sold to a factoring company (a factor) to access immediate funds. Generally, invoice factoring involves 5 steps;
- You invoice the customer
Once you sell a product or service to your customer, you issue an invoice for payment. For your business to qualify for invoice factoring, the customer should promise to pay within 90 days.
- You sell the invoice to a factor
You then find a factor and sell the outstanding invoices. Once the factor receives the invoices, there are several things that will take place. First, the company will determine whether you meet all the requirements to qualify for funding. They will also determine whether the customer(s) has good financial history to minimize the credit risk. After that, both you and the factoring provider will sign a contract agreement. This agreement clearly explains the maximum amount to be issued and the factoring fee which is mostly charged on a weekly basis until the customer pays.
- You receive the cash advance
The factor will provide an initial amount, called an advance rate. This rate falls between 70-90% depending on your industry, the customers’ creditworthiness and the financing company you decide to work with.
- Your customer pays the accounts receivable company
The customer has to pay the invoice within 90 days according to your agreement terms. The responsibility of collecting payments will be delegated to the factoring company.
- The remaining balance is forwarded
Once invoice payment is received, the factor forwards the remaining balance less the fee charges.
Who can use invoice factoring?
Accounts receivable factoring can be a smart option for any type of business that needs immediate cash to solve a cash flow problem. It is one of the powerful tools used by small business owners to help the business operate more effectively and achieve long-term growth.
Besides providing the funds, you will be relieved on the responsibility of collecting invoices, and this will give you more time to focus on the most important aspects of your business.
Invoice factoring costs
Invoice factoring offers a convenient working capital solution for businesses of every size and type. Since there are no credit scores and annual revenue requirements, startups can also qualify for financing.
Some factoring providers explain their fees in such a way that it may be hard for a small business owner to understand. Typically, you can factor amounts of up to $25,000 per month with a discount rate of 0.5-5%.
You can receive funding within 3 business days. Some factors also have additional charges in form of origination fee, increment fee, service fee and collection or overdue fees.
Since factoring companies have different charges, it is important to;
- Review the factoring contract (you can ask an attorney for assistance) to avoid any hidden charges
- Compare the rates from different companies before signing a contract
Finding the right invoice factoring company
There are hundreds of receivable factoring companies in the United States. But as much as all these companies provide invoice factoring financing, how they do business, the services they offer and the fee charges may vary.
It is prudent to carefully do your research to avoid incurring any unintended costs. Here are some of the things you should consider when shopping for the best invoice factoring company.
- Customer contact with the factoring company
One aspect that scares business owners is the level of contact between their customers and the factoring company. This is because the customers will be directly in touch with the factor. Some business owners many imagine that their loyal customers may be frequently contacted with a company that they are not aware of and this may interfere with client-customer relationship. Since no one has ever proven that these concerns are true, they still remain to be an exaggeration.
- Time to get funding
Funding time matters a lot, especially when you want to buy essential business equipment, make payrolls or start a new project. The time taken to receive a factoring loan is almost the same as getting a short-term loan. It only takes 2-7 days to qualify for factoring and you can receive the funds as soon as 24 hours.
- Recourse vs. nonrecourse factoring
Choosing between recourse and nonrecourse factoring is also important. With recourse factoring, the business is responsible for paying the invoice if the customer does not pay within the agreed upon time. You obviously would not want to take this responsibility if you have already spent the advance amount. This is the reason why it is important to only factor invoices from clients with a clean financial history. Remember that the fee charges will also increase until the factor receives the funding and this will lead to another cash flow problem. With non-recourse factoring, the factor bears all the risk if the customer does not pay. In this case, your business won’t be affected if the customer does not pay.
- Familiarity with the industry
It is also important to work with a factor that is familiar with your industry. The industry you operate in can affect factoring terms and also the cost involved. There are factors who only offer financing to specific industries while others just don’t provide financing to certain industries. Make sure that you do research and choose a factor who understands your industry needs.
If you have never used factoring services before, you may think that it is a more complicated process compared to getting a business loan from the bank. But what makes this financing option complicated is what makes it attractive.
You can easily borrow cash using your unpaid customer invoices to meet pressing business issues. The cost of factoring is also affordable compared to other forms of financing, provided your customers pay their invoices on time.