Cash flow is important for any business, but it’s especially crucial for those that are just starting out. Along with paying suppliers and employees, startups need cash to invest back into the company. They may not have the benefit of a robust savings account or line of credit to do so.
Invoice financing, also known as “accounts receivable financing” or “invoice factoring,” is one way to bring cash into a business by offering the business’ unpaid invoice value as collateral. This allows firms to support seasonal demands and cover temporary shortages when invoices are past due.
Typically, invoice financing companies (sometimes called “factoring companies”) will advance businesses 85% of the value of past-due invoices with the remaining 15% due at a later date. In exchange for the loan, the company charges the borrower a percentage of the invoice total. The cash can help businesses keep functioning during a cash dearth by allowing them to meet expenses like payroll and taxes.
Still, invoice financing is not without its drawbacks. Understanding the pros of cons of this form of business funding is important if you hope to make the best decision for your company’s financial future.
Pros of Invoice Financing
The following are benefits associated with invoice financing.
Easier Application Process
In light of stricter lending standards, many startups find themselves being rejected by traditional banks. One of the benefits of invoice financing is that the loan approval rate is relatively high. Because the financing company is only interested in your customers’ ability to pay their debts, the organization might not run a credit check on your small business. This benefit is particularly important for startup founders who may not yet have accumulated significant business credit.
Faster Cash Supply
A faster and smoother loan process means that owners can invest their capital back into the business. Not only does this cash influx allow them to secure more job opportunities, but it may also enable them to take advantage of supplier discounts or buy necessary tools to boost long-term production. As an added bonus, this cash can complement other types of financing to cover your business’ expansion or additional R&D efforts.
As a new business owner, you may find yourself struggling with unpaid invoices that you are unable to enforce. In some cases, invoice financing companies function like collection agencies, as they take on collection of the debts created by your non-paying customers. Because the factoring company is contacting your customers about late payments, you don’t have to. You can avoid being the bad guy while focusing your time and energy on company growth.
Cons of Invoice Financing
Of course, invoice financing is not without its drawbacks. Here are a few reasons that you may want to pursue other ways of funding your business.
While invoice financing allows you to get your hands on cash quickly, the cost of the loan may be significant. While costs vary, most charge a 1 to 5% fee for services along with annual interest rates between 12 and 60%. Companies that fail to make good on their invoices may wind up owing significantly more money in the long run. Before applying for invoice financing, small businesses should be confident that their positive returns are great enough to justify the costs.
Along with the lost revenue, businesses utilizing invoice financing can wind up alienating their customers. In many cases, invoice financing companies require the business in question to provide customers with a formal notification of what’s happening. Owners have to consider that customers may not be happy about having their information sent to an outside company.
Additionally, some financing companies opt to take over collection services when they provide funding. If you’re not comfortable with an outside company playing this role in your internal finances, invoice factoring may not be the way to go.
Though invoice financing can be a boon to cash-strapped small business owners, not all types of companies are good candidates for this funding method. Generally, invoice financing works best for B2B clients that deal with corporations and companies with 15-90 day payment cycles, not individuals.
Graphic designers, marketing companies and public relations firms are all strong potential candidates for invoice financing due to their industries’ reputations for uneven cash flows and long cycles. Startup owners, however, should keep in mind that their rates are likely to be higher than those of larger companies.
On the other hand, invoice financing is not ideal for retail companies and other businesses that work directly with consumers. Furthermore, if your invoices specify that they are due upon receipt, invoice factoring is probably not for you.
Of course, invoice financing is a temporary solution at best. Frequently relying on this option can leave your company open to long-term cash flow problems and contribute to overall debt. For best results, encourage clients to pay on schedule by giving them multiple payment options and sending out invoices on time each month. Doing this allows you to maximize working capital and gives your firm the best shot at succeeding.
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