What Is Invoice Factoring?
One of the biggest challenges that businesses face is getting paid. Even the most well-run organizations encounter hiccups and rely on credit as a bridge or to increase working capital.
Savvy business owners will take time to build their organizations’ credit histories and have access to a variety of financial services products from small business loans to lines of credit and credit cards. Invoice financing, also known as “accounts receivable financing” or “invoice factoring,” is one resource in a business owner’s credit portfolio.
You use your invoices as collateral for cash. That means you can collect invoices immediately rather than waiting the 30, 60, or sometimes 90 days for your customers to pay you.
As with any form of credit, invoice factoring has its pros and cons.
Pro: you can improve your cash flow and gain access to immediate cash.
Con: interest fees can add up, quickly.
Here’s a guide to navigating whether invoice financing is right for your business.
How Does Invoice Factoring Work?
Typically, invoice financing companies (sometimes called “invoice factoring companies”) will advance businesses up to 85% of the value of past-due invoices with the remaining 15% payable at a later date.
“Invoice financing tends to be expensive, so businesses can lose a fair amount of revenue,” explains Bianca Crouse, a finance writer for merchant maverick, a small business software and service review website.
“But invoice financing is useful because its a dependable way to get the cash you need to run a business, even if your customers are slow paying.”
Do the math to know whether invoice financing is right for your business. Here’s a deep dive into pros and cons, as well as a behind-the-scenes of how this short-term lending option works.
How Do Invoice Factoring Companies Make Money?
Invoice factoring companies make money by charging interest rates by day or per week. These fees accelerate when payments become late. In exchange, the company charges the borrower a percentage of the invoice total. While costs vary, most factoring companies charge a 1 to 5% fee for services along with annual interest rates between 12 and 60%.
Pros of Invoice Financing
The cash can help businesses keep functioning during a cash crunch by allowing them to meet urgent expenses such as payroll and taxes.
Still, invoice financing is not without its drawbacks.
Easier Application Process
One of the benefits of invoice financing is that the 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 significant business credit.
Faster Cash Supply
A faster and smoother process means that owners can invest their capital back into the company quickly. This cash influx may enable business owners to secure more business, take advantage of supplier discounts, or buy the necessary tools to boost long-term production.
As an added bonus, this cash can complement other types of financing.
As a new business owner, you may find yourself struggling with unpaid invoices that you are unable to enforce, which is an obvious hit to your bank account.
In some cases, invoice financing companies function like collection agencies, as they take on the 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.
To win your business, some financing companies may give your account a dedicated customer success manager. This individual will offer subject matter expertise, contact customers on your behalf, and manage your accounts receivables.
You can integrate your accounting software with your lender. Some small businesses choose to outsource all of their accounts receivables to an invoice financing or factoring partner as a result.
Cons of Invoice Financing
While invoice financing allows you to get your hands on cash quickly, the cost of the loan may be significant. Before applying for invoice financing, small businesses should be confident that their positive returns are great enough to justify the costs.
Research different financing companies to make an informed decision.
Lenders include banks, credit unions, arms of businesses such as Quickbooks Capital, and independent entities that specialize in invoice financing.
Your customers might question why a third party needs to keep involved with your business.
Invoice financing companies will need to notify your customers and in some cases, redirect payment. One way to avoid potential problems is to be transparent with your customer. Mention the benefits, to all parties, of working with a financing company, and ensure a smooth handoff.
Another System to Manage
Monitoring cash flow is challenging enough. In addition to watching your company’s bank account, business loans, and lines of credit, you’ll also need to track how funds travel to and from your lender.
There is the potential for error or for funds to slip through the cracks.
Payment Default Risk
If your customer doesn’t pay, what happens? You’re on the hook for funds that you received in advance, for which you don’t have funds to repay.
Financing large invoices can be risky if your payments default. One way to offset this risk is to only finance a portion of your accounts receivables.
Invoice factoring is a tool that can help business owners run with predictability. Cash flow predictability is essential for maintaining core operations. In some situations, you may need an influx of cash to resolve a problem or pursue unplanned opportunities. I interviewed two small business finance experts to share their best tips for using invoice financing as a tool.
Nate Masterson, Finance Manager at Maple Holistics
- Use it when you need it. If you find yourself constantly coming back to it, you’re doing something wrong. Your cash flow issues shouldn’t be so severe that you need to borrow month-to-month to keep things going. If you are, you need to find a way to cut costs, improve your collections/finance operations, or increase your revenue fast.
- Treat invoice financing as a tool for the necessary financial flexibility to make moves that are necessary for growth.
Ken Wentworth, CFO and Business Consultant at Wentworth Financial Partners
- In my experience and, unfortunately, many of these companies are on the precipice of being predatory lenders (preying on uneducated or desperate business owners) and I am a huge opponent of that way of doing business. However, if you can find a reputable company (they are out there), invoice financing can be a valuable tool in your tool belt! If managed effectively, it can help you through short-term cash shortages with minimal costs.
- You absolutely have to read and understand all of the terms of your lending agreement with them. In addition, if the situation is anything other than a short-term lending scenario – think project-based businesses that might charge at milestones, then quickly repay the balance.
- Invoice financing fits nicely into cash flow management strategies as long as the money will be borrowed for 19 days or less (dependent upon terms of your lending agreement). For longer-term cash/borrowing needs, there are more cost-effective lending options available. For example, for longer-term borrowing needs, a small business could utilize a line-of-credit, which would almost always charge a much lower annual interest rate vs. invoice financing.
The recommendations above are “lines in the sand,” according to Wentworth.
Do what is sustainable and feasible for you. For instance, you may decide that it’s worth the cost of having a third-party entity manage your receivables. You may find a partner that offers a lower interest rate, making it possible for business owners to borrow for a longer period of time.
Cash flow management is an art, after all. Invoice financing is one solution in your toolkit. Long-term milestones are the outcome of many short-term steps.