Invoice factoring offers cash flow solutions for small businesses by converting slow paying invoices into immediate cash. It is a debt-free finance solution that provides working capital to small businesses to help them cover their expenses. The factoring company normally gives you the first installment (80% of the invoice value). The remaining 20 percent is paid after the invoice is paid. The factoring company deducts its fees from the second installment.
You should not confuse invoice factoring with invoice financing. Invoice financing is the use of accounts receivable such as invoices as collateral for a line of credit or loan. Invoice financing is the borrowing of money while using invoice as collateral whereas invoice factoring invoices the sale of invoices.
Invoice factoring is a good option for businesses that can’t qualify for loans or are not willing to take out loans.
What are the benefits of factoring?
The following are the benefits of factoring.
• Immediate funding of invoices
• Reduces paperwork and documentation
• It is easy to set up an account with a factoring company
• Exempts you from some services such as customer collections
How Does Factoring Work?
- Choosing A Factor
The first step of the process is selecting a credible and reputable factoring company. Since there are a lot of factoring companies, it is important that you choose a factor that suits your needs. The following are the things to consider when choosing a factoring company.
The number of years that the factoring company has been in the business
• If it is non-recourse or recourse factoring
• The contract’s length
• Have they factored other businesses like yours before
• The back-office services that they offer
• The value of invoices that can be factored in a month
• Service Fees
- Create Your Account
After choosing a factoring company, you have to select clients that you would like to factor. The factor will evaluate if you are eligible to receive financing or not. They will then perform a due diligence check on the customers to determine if they are capable of paying. These checks can last for three business days. Due diligence involves background checks on Uniform Commercial Code liens, Tax lien search, judgment search, and other searches. You will then sign a financing contract with the factor once they approve your business. This contract will dictate the maximum amount of money that you can borrow.
- Send Invoices and Receive Funding
You should send your outstanding invoices to the factoring company. The factor will give you the first installment known as the advance rate. The first installment is usually 80% of the total amount of the factored invoice. The amount of the advance rate is determined by your industry, the transaction size, and other parameters.
The factor will either ask you to send a notice of assignment to the customers or do it themselves. This notice generally states that your company has given the factoring company the right to receive payments for the invoices you issue. Payments will be channeled to a lock box account set up by the factoring company.
Clients will receive their payments via direct deposit which takes two days to reflect on your bank account. Those who want money urgently should request for wire transfer which takes one business day to reflect on your account. Funds will only be given after the invoices are verified. Verification is done the same day you submit the invoices. The factor then sends your invoices to your clients for processing and payments.
Some industries are familiar to factoring than others. Shipping and trucking companies usually use freight factoring while recruiting agencies and staffing companies use staffing factoring. Some clients understand the factoring process and telling them that you’ve assigned their invoice won’t confuse them. It is advisable that you opt for invoice financing if your industry is not familiar with factoring.
- Customer Pays The Factor
Your customer will pay the factoring company within 90 days. The factor will handle the entire collection process on the invoices assigned to them. The factoring company will always try to adhere to your previous collection approach unless the customer fails to honor the terms of the invoice. This ensures that your relationship with your customers is not ruined.
- Getting the Second Installment
The entire transaction is settled once you receive the second installment (also known as the rebate). The value of the rebate can be between 5% and 30% of the invoice. This depends on the size of your advance rate. The factoring company will determine how the rebate will be paid depending on their policy. Some will distribute the rebate once the client pays the total amount. Others will process the rebates as a batch and distribute them weekly or monthly. The factor will deduct their service fee from the second installment.
- Ongoing Financing
Business normally factor invoices regularly since it allows them to have a predictable and ongoing cash flow. The food thing is that the procedure is easy. All you need to do is send the invoices and a list of accounts. The factoring company processes the invoices and sends you the advance. You will receive the rebate as soon as your client pays the full amount.
Is Invoice Factoring Right for You?
If you need a consistent and debt-free cash flow solution then factoring is right for you. You should be willing to partner with a factoring account and allow them to manage your account receivable. You should also allow your factor to contact your customers. They will contact your clients to verify the assignment notice, verify invoices or make payment arrangements. Ensure that you notify your clients of the new arrangement to avoid inconveniences.
Invoice factoring may seem complicating as compared to applying for a traditional loan. Truly speaking, factoring is more advantageous since you can sell the unpaid invoices to meet urgent cash flow demands. Invoice factoring is more affordable as compared to loans, as long as your clients honor the terms. The good thing is that your credit score doesn’t determine if you are eligible or not. Eligibility is determined by your customers’ ability to repay.