In this article we’ll dive into what invoice factoring is, factoring advantages and disadvantages, alternatives to factoring, and whether invoice factoring is a good idea for you.
What is Factoring?
Factoring is a short-term financing solution where a company sells its accounts receivables to a third party in exchange for immediate cash. There are two main types of factoring:
- Non-recourse factoring - Factoring companies take on full liability for collecting on invoices
- Recourse factoring - The business keeps the responsibility for collecting payment
Also known as accounts receivable financing or invoice financing, companies sell their receivables and receive 80 to 90% of invoice value from the factor. Essentially, the business receives a discounted value of the receivables, and the factoring company keeps the rest as their fee. The company satisfies immediate cash needs, regardless of whether the customer pays right away.
Is Invoice Factoring a Good Idea?
Factoring is a viable solution for companies that can’t afford a 30 to 90-day waiting period to get paid, but you need to consider the nature of your business and its financial health. Companies that choose this financing solution experience these benefits of factoring:
Immediate Cash Injection
When customers delay payments, businesses can run into issues with working capital that could cripple operations. Instead of waiting for clients to settle their payments, you can use factoring services and sell all or just a portion of your accounts receivables. If Shopline uses factoring, it can receive cash needed to fulfill other orders, pay obligations, or re-invest in the business.
High Levels of Financing with Fewer Conditions
Actual terms and requirements may vary for each factoring agreement, but lenders have fewer underwriting requirements compared to a traditional loan. For example, one of the benefits of factoring is that lenders evaluate the creditworthiness of your customers rather than business credit history. Even if Shopline is a new business with a limited credit history or poor credit, they can likely access the benefits of factoring.
Improves Financial Competitiveness
With non-recourse factoring, your company will no longer take on the risk of default. Since the company sells its receivables, it will not take on additional debt. Companies aiming for better debt-to-equity ratios can factor to settle obligations or fund purchases without negatively affecting the balance sheet. That leaves the company in a better position to secure capital if needed.
What are the Drawbacks of Factoring?
While factoring can solve cash flow problems, it’s not always the ideal solution. Businesses may not want to use factoring for the following reasons:
Factoring Can be Expensive for Low-profit Businesses
A company with many buyers but a slim profit margin may end up paying too much for factoring. While there are no strict rules, companies with a profit margin of less than 15% may not be a good fit for factoring.
Factoring is expensive, and costs may change according to customer credit quality, sales volume, and invoice diversification. On average, factoring fees range from 1 to 5%. Application fees, credit check fees, late payment fees, and other processing fees on top of the factoring fee may burn cash.
Ending Factoring Agreements Can Be Costly, Too
Factoring fees vary depending on the quality of the receivables for sale. Lenders charge lower fees if customers are likely to pay and more if the risk of default is high. At some point, you may consider ending a factoring agreement to lower your credit expenses. Depending on the number of open invoices and cash advances paid, terminating your factoring agreements can be costly.
Factoring agreements often have a term of one to three years. If you terminate your relationship with the factor before the term ends, you may have to pay a termination fee. If a fee applies, it is usually between 3% to 15% of your credit line.
Factors Can Impact Your Business Reputation
A poor experience with your factor will directly translate into a subpar experience with your own brand or business. Since the factor may take over collections, your relationship with customers could be at risk.
Factoring companies with unethical and aggressive collection practices would negatively impact your business. As a result, clients may stop doing business with you. Negative reviews also impact your company's ability to attract new customers.
What are the Alternatives to Factoring?
After considering the advantages and disadvantages of factoring, your company may find it risky or expensive. Fortunately, businesses can take precautions to avoid needing factoring services.
Invoice for Goods and Services as Soon as They’re Provided
Issue a sales invoice as the sale happens rather than processing invoices in batches or waiting until the end of the month. Clients are more likely to delay payments when they don't receive invoices on time or when it is inconvenient to pay.
Automating accounts receivable and invoicing is an effective way to make real-time invoicing possible. Electronic invoicing automates invoice creation, which reduces errors that could delay payments. By preparing accurate invoices right away and sending them on time, you can get paid faster.
Send Invoice Reminders Before The Due Date
When firms follow up within five days of a payment due date, delinquency rates are at 8.8% on average. However, when your company waits 45 days to follow up, delinquency rates increase to 26%.
Sending reminders via text or email is an effective way to remind customers about deadlines or overdue payments. Establishing regular client contact to follow up on payments helps you maintain a positive relationship while getting paid on time.
Provide Multiple Payment Options
Payment delays often happen when clients can't pay using their preferred method. Allowing customers to pay conveniently is a powerful tool for improving collections.
Expand your payment channels to cater to payment methods both online and in-person. Include digital wallet payments, debit and credit card payments, electronic transfers, digital payments, and other popular payment methods to reduce barriers to making a swift settlement.
Use Fixed Credit & A/R Automation
Factoring is convenient due to fast approval and funding, but it's not the only option. Credit management solutions like Apruve embed the fully financed credit program into the order-capture process, including a B2B ecommerce site or into an ERP.
Shopline customers, for instance, can purchase goods as usual and choose credit options that allow net terms payment. Shopline would then receive a fully-funded invoice in 24 hours. This next-day payment delivers funding similar to factoring but without the added costs and risks.
By taking over credit, payment, and collection processes, Apruve allows B2B businesses to instead focus time and energy on growth.
