Cash flow is important for any business, but it’s especially crucial for those who are just starting out. Along with paying suppliers and employees, startups usually need cash to invest back into the company.
Invoice financing, also known as “accounts receivable financing” or “invoice factoring,” is one way to bring cash into a business. Invoice financing uses the value of past-due invoices as collateral in exchange for cash.
Typically, invoice financing companies (sometimes called “factoring companies”) will advance businesses up to 85% of the value of past-due invoices with the remaining 15% payable at a later date. In exchange for the loan, the company charges the business a percentage of the invoice total. 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.
Pros of Invoice Financing
The following are benefits associated with invoice financing.
Easier Application Process
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 significant business credit.
Faster Cash Supply
A faster and smoother loan process means that owners can invest their capital back into the business quickly. This cash influx may enable business owners to secure more business, 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.
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.
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 factoring companies charge a 1 to 5% fee for services along with annual interest rates between 12 and 60%. Before applying for invoice financing, small businesses should be confident that their positive returns are great enough to justify the costs.
The other side of using a factoring company as a collection agency is that businesses may alienate 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 should consider that customers may not be happy about having their information sent to an outside company.
Though invoice financing can help 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.
Invoice financing is a temporary solution. Businesses that frequently rely on this option can leave a company open to long-term cash flow problems and contribute to overall debt.