This post was most recently updated on May 19th, 2022
Invoice factoring aids businesses that need cash but cannot yet collect on their customers’ pending invoices. Factoring companies will take over the collection for you as well as provide you with an advance weighed against the invoices’ total value.
Businesses can enjoy numerous benefits from this form of financing. It also has its own set of drawbacks for the business as well. You should familiarize yourself with these advantages and disadvantages so you can decide if invoice factoring is ideal for your current cash flow needs.
No Business Credit Check Required
Most small businesses are denied financing because of their credit scores. Some are unable to build a favorable credit standing because of defaults. Others faithfully settle their terms, but their lenders neglect to report their performance to the appropriate bureaus. Yet other businessmen are not aware of the ways to build a good credit score.
This means that small businesses become hesitant to apply for financing even if their cash flow requires it. You are probably one of those entrepreneurs. However, in invoice financing, no credit check is necessary. Factoring companies do not consider their services as a loan, but a cash advance.
Lenders will generally pass over your business credit scores, but they might check your customers’ capacity to pay. In other words, lenders only want to make sure that the invoices are valid, and that your customers can pay their debts. The better your customers’ credit standing is, the quicker that the factoring company can collect on those debts. You also receive the remaining amount of the invoices faster as well.
Cash on Demand
Invoice factoring can give you much-needed cash exactly when you need it. You already have these sales realized. All you have to do is to collect on those invoices and receive the cash. The factoring company simply advances the money to you. As mentioned earlier, they also take on the burden of collection so you can get the full amount minus the factoring fee.
This way, you can keep your cash flow stable and positive even if you still have accounts pending. You don’t have to wait until the invoices are due. Most invoices have terms that stretch up to 90 days, and problems can appear within that time. Invoice factoring gives you a huge part of that money that you can use on operating expenses like employee wages and loan repayments.
This financing can definitely help if you’re a small business that has just started its journey. You definitely need those sales to keep yourself afloat, but you cannot collect until the invoices are due. Invoice factoring will be your source of cash until you’ve built up enough sales that can sustain your expenditures every month.
Invoice factoring offers businesses a lot of flexibility. For example, you can choose to subscribe to a factoring company’s service every month. This option lets you fill the gap in cash flow if you’re expecting the next few months to be slow in sales. You can avoid issues with employee salaries or inventory this way.
You can also choose to enlist a factoring company’s service for the whole year. With this, you can stabilize your cash flow for an entire year without spending cash on in-house collection services. You can instead focus on your core business processes and earn more revenues.
You can also exercise flexibility with the invoices that you turn over to the factoring company. You can choose those invoices with higher values, or those issued to customers with a good paying record.
Reduced Collection Expenses
Employees have to be paid their wages. The law requires it. More often than not, the wages will take out about 50-60 percent of the revenues owed in your invoices. Invoice factoring can help to reduce those expenditures for you.
Invoice factoring companies hire, train, and pay their own staff to collect your invoices for you. This means that you can free yourself from allocating cash from your revenues to the wages of an in-house collection staff. All you have to pay is the factoring fee that they deduct from your cash advance.
In other words, invoice factoring helps small businesses like yourself save money. You can use the extra cash to reinvest in the business, acquire crucial inventory or disburse as dividends to your investors.
No Interest Rates
If you recall, invoice factors do not consider their financing as loans. They don’t charge interest. This means that invoice factoring can be a cheaper option than business loans. You need not worry about your obligations compounding at the end of the 90-day collection period.
All you pay for is the factoring fee. It’s a fee calculated as a percentage of your cash advance and is generally lower than 10%. Let’s look at an example involving Company X and Factor, with total invoices valuing $100,000.
Factor decides that it will settle on an advance rate of 80% for Company X. This means that Company X will receive $80,000 as a cash advance. The factor will return the remaining 20% once the 90-day collection period is over. The factoring company earns profits on this transaction by deducting a 5% factoring fee from the cash advance.
How much does Company X receive in total? Based on the 5% factoring fee, the business will receive $96,000 in total. Company X will receive $76,000 as an upfront cash advance, which is $80,000 minus $4,000 in factoring fees. The factoring company will turn over $20,000 at the end of the collection period.
Your Assets Remain Safe
Another advantage of invoice factoring for businesses is a lack of collateral. Other forms of financing like equipment and inventory financing requires specific assets as collateral. While collateral hastens the approval process, it also puts business assets at risk of seizure. Your lenders will repossess your assets if you fail to pay off the loan.
Assets are very important to small businesses and startups. Losing property and fixed assets will break the business. Assets are income-generating, and repossession will mangle your cash flow. You’ll also find it difficult to secure financing to purchase new ones. This is because your credit score will be affected by your previous default.
You don’t have to worry about those with invoice factoring. All you need are your ledgers of invoices, and you’re good to go. You don’t have to repay the invoice factoring company anything outside of the factoring fees that you pay.
A Whole Suite of Services
Invoice factoring companies offer multiple services in addition to invoice factoring. One of these services is credit checking. These factors will typically research your customers’ credit rating as part of the approval process. You could get this service as a free add-on or pay an additional fee. This depends on the package you subscribe to from the factor.
As part of credit checking, factoring companies can generate credit reports for you as well. You can use this service as a background check for new customers. You can also keep yourself updated with any changes in your customers’ credit ratings.
Things to Consider Before Having Your Invoices Factored
You can save yourself some time and effort by finding out early if you’re qualified for invoice factoring. Here are some questions you can use as a guide for determining your eligibility for factoring.
Do Your Customers Have Good Credit?
Businessmen will always want to settle their financial obligations on time. However, being a good-paying customer is not always an indication of a good credit score. Some businesses have bad credit and are trying to improve it by settling dues promptly. You might want to run a credit check on all your customers, or at least those whose invoices you want to factor.
Do You Have Tax Liens From the Government?
Lenders may not check your credit score, but they will want to have a sole claim on your accounts receivables. Unfortunately, a Notice of Federal Tax Lien from the Internal Revenue Service will signify that the government also has a claim on your assets. Those receivables are also assets, and a government claim could lower your chances of getting approved.
Are Your Customers Under Financial or Legal Trouble?
Financial and legal troubles negatively impact any business’ ability to repay debts. A customer that’s facing a lawsuit or is having cash flow problems means liability for the invoice factoring company. This particular customer might not be able to pay within 90 days. If a lender finds too many of these invoices in your ledger, you might end up getting denied.
Before applying for factoring, make sure to vet through your invoices and avoid turning over those sent to financially or legally troubled customers.You don’t have to turn over all invoices, after all. Choose those that can increase your chances of approval.
Are Your Customers Involved in High-Risk Industries?
Most invoice factoring companies have an aversion to high-risk industries. These industries include the hospitality, medical, construction, transportation, and legal industries. Knowing if any of your customers are working in these industries can help you narrow your options when looking for invoice factoring companies.
The Bottom Line
Invoice factoring is ideal when you’re expecting payment for invoices in the future but would like some cash for your immediate needs. You can seek a cash advance from factoring companies, which will then collect on those pending invoices for you. You don’t have to worry about your credit score, as these lenders will disregard that during the approval process.
Aside from forwarding you the needed funds, factoring companies can also help you save money on other expenses and other add-on services. They spare you the expense of paying for collection teams’ wages. They could also do credit checks on your customers on your behalf.
However, factoring has a set of specific criteria that you and your customers have to comply with to avoid getting declined. For instance, you should not have tax liens on your assets. You must not have too many customers working in high-risk industries or who are currently facing legal and financial troubles.