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Invoice Factoring is a service provided by a company called a factor. The factor buys outstanding invoices and handles collection of payments from customers. The factor advances 70% - 95% of the paid amount of invoices to the business. The remaining amount is held by the factor. Once the factor collects payment from customers, the balance held is paid to the company minus the factor's fee.
The main reason a company will use invoice factoring is to help cover a short-term cash flow shortage. This is in contrast to using such a service to finance ongoing operations.
The following is a preview of what is covered:
- Advantages Of Invoice Factoring
- Filling Cash Shortfalls
- Invoice Factoring Vs. Financing
- Pitfalls Of Invoice Factoring
- Cost Of Factoring (Spot and Contract)
- Choosing An Invoice Factoring Company
We start off with a simplified infographic that provides an overview of invoice factoring. Click the infographic for a larger view. Scroll down below the infographic for further details on each area.
Advantages Of Invoice Factoring
The biggest advantage with invoice factoring is that it can fill a cash flow shortage immediately. If you have outstanding invoices, rather than waiting 60 to 90 days for payment, the factor can advance payment to you immediately.
You also do not have to take on debt. Invoice factoring isn't a loan and no debt will show up on your balance sheet. Its your cash. You are simply making arrangements to receive it sooner than usual.
In some cases, business owners might turn to equity investors to help them build up cash and plug cash flow holes. Equity investors will often expect a return on capital that is much higher than that of accounts receivable factoring. Owners also must give up part of their business through equity dilution. Most factoring arrangements do not involve equity stakes.
The factor will take care of payment collection from customers. This frees up your time to focus on business operations.
Filling Cash ShortFalls
Businesses can find themselves in unexpected cash flow shortages and in need of cash immediately. This scenario is usually amplified by startups, who are often spending more than they take in and chronically short on cash.
Invoice factoring can help both established companies and startups fill their cash flow gap. The turnaround on invoice factoring is fairly quick. Companies are often paid within only a few hours to a few days. This makes invoice factoring a popular choice when cash is needed immediately.
Invoice Factoring Vs. Financing
Invoice factoring and financing are sometimes used interchangeably. They are very different concepts.
Businesses will use financing to purchase equipment or to place a large order for supplies to meet customer demand. Financing allows the business to grow where otherwise it would not have been able to. Financing is usually done through longer term loans with lower financing cost than invoice factoring.
In contract, invoice factoring is meant to solve an immediate problem. Namely that of a cash flow shortage.
With financing, the business is not in an immediate need of cash. The problem financing solves is not short-term in nature. Instead, business growth is planned out over a period of time with the assistance of financing.
Financing will usually offer various terms to the business. Invoice factoring is usually set by the factor with little room for negotiation.
Pitfalls Of Invoice Factoring
Invoice factoring cost more than traditional loans. Due to its transactional nature, factors must verify every invoice and ensure customers are creditworthy. This is a labor intensive process.
Cost can vary widely between factors. It's important to shop around for the best deal.
Factors may charge based on different fee structures. This can make comparing factors difficult.
Factoring arrangements can become complex. Some factors may charge based on transaction while others may charge based on percentage of outstanding invoices. It isn't uncommon to find factors whose fee structures use both methods.
For seasonal businesses, factoring may not offer much of an advantage during seasonal downturns. Outstanding invoices are likely to decrease during any seasonal contraction, which means the amount that can be factored will contract in kind.
When working with a factor, you give up control of payment collection since accounts receivable is assigned to the factor. Your customers' accounts payable departments will be notified that any payment should be directed to the factor's lockbox. Business owners obviously get nervous about introducing this 3rd party element into such a critical part of the customer relationship. However, for many industries, factoring is very common. If it isn't common in your industry, you might want to let customers know what is happening so they fully understand the relationship with you and the factor going forward.
Invoice factoring is a labor intensive process for business owners. It's not as if the factor is able to look at a business' accounts receivable, determine what is outstanding and take it from there. To get anything factored, you must fill out forms for each invoice or batch of invoices. Details of these invoices must be spelled out for the factor. All of this eats up valuable time for business owners.
Cost Of Factoring (Spot and Contract)
There are generally two types of factoring that business owners can choose from - spot and contract.
Spot factoring is also known as single-invoice factoring. It allows the business to factor just a single invoice rather than multiple invoices.
Contract factoring, also called high volume factoring, is the more common form of factoring. In this scenario, business owners process most or all of their invoices with the factor.
Fees vary across both models. Spot factoring is higher than contract factoring. With spot factoring, the factor doesn't really have the necessary time for getting to know your business and customers. This means the factor is taking on additional risk that aren't there with contract factoring.
Spot factoring can involve a number of one-time fees. These can include wire or ACH fees, startup fees, and overdue fees.
Contract factoring also involves one-time fees but it is a longer term relation with the factor. Once you pay the initial fees, you don't have to pay them again as long as you are still in the relation. With spot factoring, you'll have to pay one-time fees with each invoice.
Recourse is another consideration with factoring cost. Many factor agreements use recourse factoring. This means that if a customer goes bankrupt or is unable to pay their invoice, you must buy it back.
Non-recourse factoring, which is very rare, means you do not have to purchase the invoice back from a customer who is unable to pay. While non-recourse is rare, it is more rare for spot factoring.
Choosing An Invoice Factoring Company
We'll start this section by going over the various fees you'll want to look out for. In general, a factor's fee structure will include the following:
- Factoring fee ranging from 3% to 8%
- Fixed processing fee
- Initial fee to setup the contract
- ACH/Wire fees
- Overdue fees
There can be a number of other fees and penalties that can be involved. This is why reading the fine print is to your advantage. Some factors may charge a penalty if you get out of the contract early. If a customer is unable to pay, you might be required to buy back the full invoice, even if you were already advanced 90% of its value. There can a penalty for not meeting the monthly minimum as outlined in the contract.
Experience should also come into play when choosing a factor. Experience can vary widely among factors. A 2017 survey by factoring.org found that 25% of factors have been in business 5 years or less with 37% having been in business 16 or more years. It's also important to choose a factor within your industry or who understands your type of business.
Reputation might fall into the experience category but a factor can be in business for a long time and not have the best reputation. It's important to do all the research you can about any factor your are considering. There are likely to be articles on the Internet about the factor that can help reveal customer experiences or additional information on how the factor operates.
Additional considerations when choosing a factor include your own experience in asking questions. Are they forthcoming with answers? Do they respond in a timely manner? Are they willing to negotiate at all on the rate and contract terms? Does the company offer any type of system that lets you track payment collection progress without having to call or email the company to get updates?
Invoice factoring can be a great way to help businesses fill a cash flow shortage. It isn't a long game though. It is meant to solve a short-term problem. If cash flow shortages are occuring more frequently than you'd like, seeking out solutions that can handle longer term financing are a better options.