Chasing your clients after completing the project feels embarrassing and tiresome. Isn’t it?
All business entrepreneurs must have faced or are facing such a situation due to some of their slowing paying customers. Delayed payment can stall your business operation and would hinder your business growth fiscally.
Wandering, as to how you can turn your unpaid customer invoice into fast cash flow?
Solution: Invoice Factoring
Here’s what it actually means!
What is invoice factoring?
It is an invoice financing process where you ‘sell’ some or all the invoices to a third party to get all your outstanding invoices cleared within a certain period. It is beneficial for your business as it gets all your accounts receivable faster in exchange for a small amount of factoring fee.
Let’s discuss with an example for a better and clear conceptual understanding!
Invoice Factoring Example
|Total Invoice Value||$15000|
|Invoice factoring fee||3% = $450|
|85% of invoice value as an initial advance||$12367.50|
|The remaining advance of 12%||$2182.50|
|Total amount received||$14550|
The above table represents how your invoice value is factored when you sell it to a factoring company.
Suppose your total invoice value is $15000, the calculation would start at $14,550 as a 3% factoring fee will be charged by the company. Out of the total $14550, 85% of the value will be paid by the company within a few days and the remaining amount will be paid after the factoring company collects the due invoices.
Note: The invoice factoring fees range between 1%-5% depending upon the invoice value, sales volume, etc.
It is an effective way to clear all your outstanding invoices. Here’s how it actually works to get paid faster.
How does invoice factoring work?
If you are wondering how invoice factoring is beneficial for your business, then you have to know how it processes your dues.
Companies or business owners deal with numerous invoices every month and often get stuck with some, due to payment delays. Needless to mention, it stunts the business operations and creates a constant financial backlog. This is when invoice factoring helps to clear all the outstanding payments smoothly.
How?- Suppose, you are stuck with a bunch of invoices. You sell those to a third-party invoice factoring company. They pay you full or some portion of the invoice amount after verifying the invoices. Then they proceed further to get the payment from the respective client. Then they pay you back the remaining amount after deducting their service charges. This technique is so effective that in some cases the payment is received within 24hours. Unimaginable right?
Note: The unpaid invoices should not be more than 30 days old.
It keeps your cash flowing and takes off all your stress. It keeps your other business expenses rolling while you don’t have to bother about the unpaid invoices. As per the Wall Street Journal, some factoring companies remits 70%-90% of the invoice amount and deducts 3% of the total amount as a transaction fee after receiving the entire due amount.
Invoices are piling and payment reminders are not helping – that’s when you turn up to invoice factoring company.
When to use this technique?
You already know how invoice factoring helps your business overcome the stress of recovery due payments. You may have set net-30 payment terms, and some of your clients do settle the payment within the time frame, but some other of your clients may require chasing.
So, when a situation arises where you have a lot of outstanding invoices, and your cash flow is suffering severely, that’s when invoice factoring helps release a large chunk of your revenue immediately.
So this is an effective technique that can help you bridge your short-term expenses, repay loans, and also let you benefit from the seasonal business opportunity.
Though it is of great importance from your business cash flow perspective, it may not seem equally advantageous for small businesses. How?- Here it is!
Pros of invoice factoring
- Speeds up account receivables: By implementing this process you can cover up your funding gap created by slow-paying customers. It helps you get paid faster and also helps in accurate and flawless business planning and forecasting.
- Improved cash flow: It speeds up cash flow that helps you to cover up all your day-to-day business expenses. Better cash flow provides you with business security and boosts your business growth rate.
- Easier approval for bank loans: Limited operating history or poor credit score can drop down your chances of business loan approval. Invoice factoring clears your outstanding invoices and improves your chances of getting a loan sanctioned seamlessly.
- Reduces business overheads as no collateral required: It helps you deal with your business overhead expenses and reduces them to a substantial amount. Thus, it is a potential tool for developing business growth as no collateral is required.
Cons of invoice factoring
- Cost-effective: Invoice factoring often comes with hidden fees which may cost you more than you have expected. Hence, businesses dealing with a fewer number of invoices each month may not find this a suitable tool for recovering their due amount.
- Affects customer relationships: Invoice factoring companies collect the money themselves, therefore it may affect your relationship with your clients. As it might cause losing direct control over your clients which may seem unfair to them.
- Demands big commitments: Though selective or spot factoring is possible, some of the factoring companies demand a long-term contract (e.g., 2 years) before moving forward. Hence, you need to give it a thought as it requires a major business decision.
- It may be risky if the customer is not creditworthy: Recovering the dues depends solely on the creditworthiness of the customer. Hence, some factoring companies may step back if they don’t find the required customer credibility and it might affect your business.
- Not a trustworthy method of collection due amount: There is no certainty that the factoring companies will be successful in collecting the unpaid invoices. Instead, it may lead you to buy back the invoices in an equal or greater value.
Some additional information about invoice factoring:
Are invoice factoring and invoice financing the same?
Though these sound similar, they are a bit different from each other. Invoice financing does not involve selling them to a factoring company. Instead, invoices are used as collateral to get the cash, unlike the invoice factoring mechanism. The business is solely responsible for recovering the overdue payments.
Invoice discounting and factoring- is it the same or different?
Yes, these are synonymous terms and have the same utility. Invoice factoring is not a loan, it is the ‘sale’ of the invoice, which relinquishes all your collection hassle and ends late-payment worries. It helps to clear dues within 24 hours in most cases, secures your assets, and increases your turnover funding level.
How are recourse and nonrecourse factoring different?
The difference between recourse and non-recourse factoring is- who is liable to the risk of non-payment of invoices from the customer’s end.
Recourse factoring companies return the fund in case the customer fails to pay back the due amount. While the non-recourse companies bear the obligation of absorbing the unpaid bills.
Hence, resource factoring is not very beneficial for a business as credit risk persists in case of non-recovery of the due amount. Whereas, non-recourse factoring provides business financial security and business remains unaffected if receivables are not recovered.
Does invoice factoring save your money?
Invoice factoring converts all your due invoices into cash almost immediately and which keeps your business cash flow steady and stable. This in turn helps you pay off your bills, clears the payroll of your employees, and saves money in the process.
Note: This can only help when you can guarantee the creditworthiness of your customer. Hence, it may be quite risky for small businesses to deal with only a few invoices every month.
How much does invoice factoring cost?
The prices generally vary from company to company. Some of the invoice factoring fees are:
- Application fees: Some invoice factoring companies charge while some do not. It generally ranges between 0-$1000 depending upon the type of company they are dealing with.
- Closing fee: Some companies may retain a certain portion of each invoice as closing fees.
- Monthly fee: Some companies charge a fixed amount if the monthly target is not achieved.
- Termination fee: For terminating the contract before the tenure some factoring companies charge cancellation/termination fees.
- Discount fee: Generally 1.5-5% of the invoice amount is charged as discount fees by the factoring companies as a cost of paying you the invoices in advance.
- Factoring fee: A factoring fee of around 2-3% is charged by some companies if invoices go beyond 30-45 days. Some charge on a daily basis while some on a 10-days basis for outstanding invoices that go beyond the original date.
Invoice factoring is an effective business partner that makes your financial challenges a thing of the past. It eases your invoice recovery hassle-free without affecting your business. But despite all its advantages, do give a second thought as it might be risky and not beneficial for small businesses.