What is invoice factoring? How it works and its pros, cons
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Originally Posted On: What is invoice factoring? How it works and its pros, cons | QuickBooks (intuit.com)
From replacing equipment to paying off bills, making money as a small business requires a lot of money—but you may not always have the cash flow to handle it all. Invoice factoring, also known as accounts receivable factoring, gives small businesses the chance to quickly access working capital by turning unpaid customer invoices into cash.
In this post, we explore how invoice factoring works, what it costs, its pros and cons, and more. Read on for a thorough explanation of invoice factoring, or use the links below to skip to the section that best answers your query.
Invoice factoring is a financing method that allows businesses to sell unpaid customer invoices in their accounts receivable to third-party invoice factoring companies. Invoice factoring can help small businesses access cash for short-term financing needs.
After purchasing outstanding invoices from a business, the invoice factoring company will send the business a portion of the invoice amount upfront. They then collect payment from your customers within 30 to 90 days. Upon payment, the factoring service will pay the remaining balance to the business.
Invoice factoring leverages a small business’s outstanding invoices by turning them into cash. Here’s how it works.
Let’s say your small business needs $20,000 to replace some necessary equipment, but you don’t have the working capital to do so. Rather than reaching out to a traditional bank for a loan, you decide to take a look at your accounts receivable.
After some investigation, you find that you have $25,000 in outstanding invoices. You decide to sell your accounts receivable to an invoice factoring company. The company says they’ll form an invoice factoring agreement with you and buy your accounts receivable for the value of the invoices minus a factoring fee of 4%.
You agree to the terms, so the invoice factoring company says they’ll pay you a total of $24,000 for the invoices. Typically, these vendors will initiate a cash advance for a portion of the total purchase within a few business days. Cash advance rates are generally around 85%. After they’ve collected all payment for the invoices, they’ll send you the remaining balance.
Now that you’re more familiar with the invoice factoring process, let’s take a look at an example using the figures from above.
Invoice factoring companies turn a profit on your unpaid invoices by buying them from you at a discount rate that is lower than the original invoiced amount. This discounted rate is also called a factoring fee.
If the factoring company buys your outstanding $10,000 invoice and they charge a factoring fee of 3%, they stand to profit $300. Average factoring fees typically range between 1% and 5%.
Not quite. Like a loan, invoice factoring does grant you access to capital you don’t have at the moment, but it’s not technically considered a loan. Rather than lending you money with the expectation that you repay the loan, an invoicing factoring company buys up a batch of your invoices in exchange for cash. Within 30 to 90 days, they’ll earn the money back when they collect payment from your customers. As mentioned, you’ll receive the remaining balance of your invoice factoring agreement upon customer payment.
There are a few other differences to note when comparing traditional bank loans and invoice factoring:
- Invoice factoring companies look at your customer’s creditworthiness more closely than your own. That’s because your customers are the ones responsible for repaying the debt, not you.
- Invoice factoring is an unsecured method of financing, which means that, unlike a bank lender, an invoice factoring company does not collect collateral.
Like any financing decision, there are several pros and cons associated with invoice factoring. Let’s take a closer look at some of the benefits and drawbacks to consider before moving forward with invoice factoring.
- Simplified approval: Invoice factoring can be an easier way for small businesses to get quick cash. The approval process is typically faster and less rigorous than a typical loan application process where lenders consider things like your personal credit score, creditworthiness, and collateral.
- Quick access to cash: Because the application process is usually faster and requires minimal paperwork, small business owners can gain access to working capital more efficiently. Factoring services typically transfer funds directly into your business’s bank account via ACH.
- No collateral needed: Unlike secured loans, invoice factoring is an unsecured form of financing and, therefore, doesn’t require any collateral.
- Cost: While invoice factoring allows you to get cash quickly, it can end up being more costly than other forms of financing. The average factoring fee is between 1% and 5%.
- Availability: Invoice factoring doesn’t work for all business models. If your business doesn’t use invoicing to collect payment from customers, you won’t have any invoices to convert to cash.
- Relinquished control: When an outstanding invoice is in your hands, you can contact your customer to complete payment according to your payment terms. But when you sell invoices to a factoring company, you release collection control to a third party.
- Issues if customer fails to pay: If your customer fails to pay their balance back and it’s a recourse factoring service, you might be required to buy back the invoice. If you’re working with a non-recourse-factoring service, they will assume the loss and you will not be held responsible for the customer’s failure to pay.
As we mentioned, invoice factoring isn’t the same as taking out a traditional loan from a bank. This is because there’s no collateral required and it’s usually easier to get approved.
It depends. Invoice factoring is just one financing option to consider. To assess whether invoice factoring is right for your business, make sure to consider your business goals, financing needs, and the value of your unpaid invoices.
Invoice factoring is just one way you can use your outstanding invoices to access quick cash. The other kind of accounts receivable financing is called invoice financing. Similar to factoring, invoice financing allows businesses to obtain a cash advance by borrowing against unpaid invoices. The difference is that, instead of selling off invoices, you’ll have to repay your lender or invoice financing company the amount you borrow. Unlike factoring, invoice financing is considered a loan or line of credit.
If your business is experiencing cash flow problems and you need access to immediate cash, invoice factoring can be a viable option. However, like most financing methods, there are drawbacks and additional fees associated with accounts receivable factoring. The good news is, there are more small business financing options if you find that invoice factoring isn’t the right fit for your needs.
Additional financing options include:
- Small business loans
- Peer-to-peer lending
- Business credit cards
- Small Business Administration loans
- Equipment financing
- Business/merchant cash advances