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A Small Business Owner’s Guide to Invoice Factoring

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Cash flow problems can be one of the most damaging issues business owners face when running a business. In fact, 82% of small- to medium-sized enterprises (SMEs) fail because of cash flow mismanagement. While there could be many possible reasons for this, one of the common culprits is unpaid and aging customer invoices. 

Many business owners would think that applying for a term loan for banks could help, their stringent requirements make it challenging for small businesses to get approved of the financing. If you’re one of the many who has trouble securing traditional financing, invoice factoring is a viable choice for you. 

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This article will dig deeper into invoice financing or factoring for small businesses. We’ll discuss what invoice factoring is, how it works, the different types, and why it could be the right choice for SMEs. 

Invoice Factoring: What is It?

Invoice factoring is a type of business funding option where businesses sell their outstanding invoices to third-party companies (factoring companies) and get cash upfront. Since you’re making a sale to the factoring company, invoice factoring isn’t technically considered a loan. With that said, the financing won’t affect your credit, unlike traditional business financing

Since it allows businesses to free up needed cash tied up on their accounts receivable, invoice factoring is also referred to as accounts receivable financing. Companies won’t have to wait for weeks or months for their customers to pay them and resolve any cash flow issues they might be having. 

How it Works

Companies that have to wait for 30 to 90 days to get paid are often the ones that experience cash crunches. It’s because of that reason that they ask for the help of factoring companies. 

Invoice factoring typically starts with a business selling their invoices to give their cash flow a boost. They can use the additional cash to meet day-to-day expenses, product expansion, buy inventory, emergency purposes, and other growing pains. However, although the company is selling their invoices, they won’t be paid the full amount for the invoices. 

Typically, factoring companies advance 70% to 95% of the total value of the accounts receivable. The remaining 5% to 30% will serve as the collateral for the factors until the customers pay off the balance. It’s how they mitigate the risk they’re taking when granting financing to businesses. 

Once the business sells the invoices to factoring companies, they will have to give up their full control of the ledger. The factoring company takes over and handles the payment chasing and collection. As the customers pay the invoices, the financing company will deduct the amount they paid businesses, plus the factoring fee then gives the remaining balance back to the business.  

Two Types of Invoice Factoring

In general, invoice factoring comes in two types: recourse and non-recourse factoring. The main difference between the two is who shoulders the responsibility of the non-payment of the invoices. 

Here’s how each of them works:

Recourse Factoring

Recourse factoring is the most common type of invoice factoring that most factoring companies offer. This is because, in this arrangement, the risk ultimately rests on the businesses. In the event of non-payment, the business would be liable for the unpaid invoices. 

Recourse factoring is a relatively cheaper alternative for businesses. Since factoring companies will only advance a portion of the invoices’ total value, businesses won’t have a hard time repaying the advanced amount in case of a default. 

If the client fails to repay their invoice within the designated period, this can create a cash flow issue for businesses as they’ll have to pay the advanced amount back. If a situation like this happens, companies ultimately have three choices:

Non-Recourse Factoring

In non-recourse factoring, the financing company will be responsible for the invoices – whether the customers pay them or not. The risk will stay with the creditors, and the business will never have to deal with the invoices again once they sell them. 

Since this arrangement presents a greater risk for the factoring companies, only a few offer non-recourse factoring. Even if they did, entrepreneurs would have to make sure that their customers have a good credit background. 

When it comes to the cost, non-recourse factoring can be more expensive than non-recourse factoring as the factors would assume the full risk of the financing. It will also come with different stipulations, so it’s smart to study the fine print before signing the contract. 

Why Use Invoice Factoring

Invoice factoring is one of the most convenient financing options you can apply for when you’re in a cash crunch. If you’re always on a cash strain because of unpaid invoices, factoring can help you unlock the cash value of your accounts receivable

Here are eight benefits of invoice factoring:

1. Easy to qualify for

Factoring companies don’t look at your credit background. Instead, they will consider the credit scores and financial history of your customers. This is the key difference between invoice factoring and other types of business financing and the biggest benefit of invoice factoring. Even if your credit standing isn’t that ideal, you’ll still have a chance of being approved of the financing.

2. Flexibility

Unlike other financing options where there’s a limit to how you can use the funding (i.e., equipment financing), invoice factoring gives business owners flexibility. In other words, the entrepreneurs can choose how and when they use the money. It could be to bridge cash flow gaps and meet day-to-day expenses or use the funds towards product expansion, payroll software, renovation, inventory, supplies, tech upgrades like usage of InvoiceBerry tool for accounting management, medical appointment setting services, etc.

3. Fast approval

Applying for invoice factoring doesn’t require businesses to go through tedious processes and submit multiple documents for proof. In fact, other financing companies offer online applications and can approve them within 24 hours. Once you get approved, the financing company then wires the money to your account in the next day or two. 

4. Save on resources

Small businesses, especially start-ups, typically don’t have enough resources to handle payment chasing and collection. Invoice factoring could be a viable solution for this. Factoring companies will handle the payment chasing and collection on your behalf. With this benefit, you won’t have to worry about nagging your customers for payments. Instead, you can focus your efforts on your business’s vital aspects (i.e., business growth strategy planning, marketing, or sales).

5. Receive immediate cash 

When applying for traditional financing programs, it often takes weeks or months to receive approval. On top of that, it takes even more time to receive the funds you qualified for. On the other hand, invoice factoring allows you to receive the money upfront or within 24 to 48 hours. This makes it a great option for businesses that are often faced with short-term financing needs and can’t afford to wait for months to get approved of a loan.

6. No need for collateral

Small business loans often ask for collateral to secure the loan. But with invoice factoring, your pending invoices serve as collateral. You don’t have to worry about pledging any personal or business equipment, real estate, and other valuable assets. 

7. Improve customer relationships

Small business owners juggle several responsibilities at once, and sometimes, running a business can be challenging. Following up on customer payments is never fun, but if you hand over this responsibility to a lending company, then you don’t have to worry about debt collection. Plus, you won’t look like the bad guy to your customers. This helps you maintain positive and long-lasting relationships with your client base. 

8. Lower the risk of late payments and bad debts

Late payments and bad debts can be detrimental to your business’ financial health. While you can always take legal action against debtors, this action can be lengthy and costly. Another option is to work with a factoring company. As mentioned, factors collect the payments on your behalf, which means they have professionals who know how to deal with people who are likely to pay past their due dates or fail to may payments at all.

Final Thoughts: Is Invoice Factoring for Small Businesses Right for You?

Applying for invoice factoring for small businesses presents a lot of benefits for business owners. Mainly, this type of business financing allows them to free up cash tied up on their invoices. With that, they won’t have to wait for 30 to 90 days to get payments. This helps solve cash flow issues the business might be experiencing because of aging outstanding invoices. 

However, it’s also worth noting that when using a factoring company’s services, the business’ customers would be aware of the relationship between the business and the factor since the customers will be paying directly to the factoring company. If you’re uncomfortable with this, you might want to look at other invoice financing types, such as invoice discounting. 

Nevertheless, if you’re looking for a quick way to obtain cash but haven’t had any luck with traditional loans, invoice financing could be a viable financing option. 

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