Invoice Factoring – What Is It & How Does It Work?
Businesses often face shortages in financing while holding large sums of money in invoices. Good news however, is that there is a quicker way for businesses to convert their invoices into cash and finance their interests! Invoice factoring is a form of invoice financing that gives businesses the power to cash in invoices. So, what is invoice financing, and how can you take advantage?
What is Invoice Financing?
Invoice financing is the action of selling the debt form of pending invoices to another business. The businesses that buy invoices are called factors. Invoice factoring is done to improve revenue stability and improve cash flow.
The factor pays the business an amount equivalent to the invoice less some fees. Typically, the factor pays 80% to 97% of the invoice and waits for the customer to pay the debt. Once the customer pays the factor, the factor clears the remaining amount after deducting the factoring fee.
There is a reduction in receivable finance from the customer. However, this is a good option when a business needs urgent cash since factors give you the cash immediately to continue with the business’s operations.
Depending on the contact in place, the factor may receive all the customer’s payment and, in some instances, may chase the customer for payment. As noted, the factoring company will give you most of the invoice payments immediately, and the last part when your customer pays them.
In fact, this process takes the cost, effort, and time required to recover debt so you can concentrate on building your business. It helps improve a company’s cash flow position in a short period. Cashflow is any financial inflows and outflows in a business.
When to use invoice financing
Knowing factor invoicing is not enough; you need to know when to use the option to build good financial habits. Here are situations when it is appropriate to use this finance option.
- Meet short-term financial obligations
You will use account receivable financing when facing some financial constraints. Some of the issues may arise from the late payment of invoices by customers. While you may be able to wait for the customers to remit payments, the bills won’t.
Using this option, you get quick cash to improve the cash flow position and payout bills. You can pay out loans to avoid the late payment penalties and the interest rates associated. Rents and payroll costs are some of the short-term obligations you manage with this financing option.
- If you have long-term payment terms
Long-term payment attracts many customers; however, many pending invoices are a liability to a business. You can give customers good value and make quick money by factoring.
Small and medium companies can take advantage of this method of invoice financing. These sorts of companies’ financial resources are not sufficient to pay expenses while waiting for invoices to mature. Account receivable financing provides a sustainable way for these companies to meet customer demands and business expenses.
- To get new clients
Turning away clients is never a smart move. But when a company doesn’t have enough financial muscle to take on new clients is the only route that it can take. Factoring gives a company a new financial strength.
Please take advantage of any business opportunities when they are available. Quick cash from the invoices helps you take advantage of business openings and increase cash flow volumes.
Types of Factoring
Not all forms of invoice factoring are created equal. Every financing contract has different conditions that make it fundamentally different from the others. Let’s check some of the main distinctions between different account receivable financing.
- Recourse versus non-Recourse financing
Recourse factoring implies that you have the debt’s liability whether or not your client pays the debt. That means that if your client fails to make payments to the factor, it is up to you to pay the full amount received from the factor plus the interests. It is the most common practice in factor financing. Always have money in the books to sort out your factor in case your client goes rogue.
Non-recourse is where a factor buys the invoice together with any liabilities associated with the debt. In this form, you don’t have to worry about the factor showing up on your doorstep because your client went cold. Awesome!
Everything good comes at a cost. So, what is the caveat? First, factors give such good terms at higher interest rates compared to recourse financing. The other thing factor that looks out for is clients with defaulting credit history. In case you have such a client, it is up to you to claim the cash later or let it become a bad debt.
Non-recourse factoring is better than recourse factoring in most cases though it is more expensive. However, it is good to understand that non-recourse factoring liability depends on the contract between the two parties. If your client goes bankrupt, there are chances your factor will take liability, but you may still be in hot soup in case of company dissolution.
Spot factoring versus contract factoring
You can work with a factor on a single invoice at once and cut your relationship. However, if your business has multiple invoices that need to be converted, it is often easier to get a long-term contract. Long term contracts are cheaper compared to spot factoring.
The factoring processes
What process do you take to start invoice financing? Here are the steps you can take to get invoice financing.
- You provide good or services to a client.
- Sent the client an invoice
- You sign to agree with a factor and receive payment of at least 80% of the total invoice.
- The client pays the invoice.
- The factor pays the remaining part of the invoice less the factoring fee.
Costs involved in factoring
The factoring fee – These are the amounts paid as a commission on the total invoice factoring.
Administration fees- Some factors require a monthly fee to administer follow through invoice.
Credit insurance- Some insurance firms require credit insurance unless the invoices are from creditworthy customers.
Cash Flow management is not simple, but invoice financing can go a long way in quickly improving its cash flow position. The cash is used to solve short-term cash flow problems. However, this method should not be overused for long-term cash flow issues. Preferably make use of debt management to take care of cash flow issues.