An Invoice Factoring Guide for Business
Welcome! If you’re a small business looking for information about invoice factoring, you’ve come to the right place. We are staunch advocates for factoring- a funding option that doesn’t incur debt. Today, small businesses need to be wary of the amount of leverage in our financial system and the dangers of being overly-indebted.
Invoice factoring is the discounted sale of accounts receivable to a third-party. It’s a funding strategy that provides fast funding without debt. That is because the sale of outstanding invoices is an asset sale, not a loan.
The idea has been around for centuries-Greek merchants utilized the practice to finance lengthy shipping ventures. Today, factoring is basically the same.
When a small business performs a service or delivers goods on credit, they invoice their business customer, and wait for payment. And wait. This can take 30, 60, even 90 days depending on the customer and the net terms.
The resulting cash flow deficits makes running a business very challenging. Your business has to make payroll, buy inventory, pay bills and accept new projects. Instead of waiting for payment (and spending valuable resources on collection efforts) businesses sell their outstanding invoice to a third-party factoring company. Effectively, the business has sold the rights to collect on the invoice to the factoring company.
How does Invoice Factoring Work?
Here’s an example. Assume a factoring company is considering buying a number of outstanding invoices from a small business. They conduct due diligence on the invoiced customer, including credit checks and searches for outstanding liens and lawsuits. The factor is confident of repayment, and decides to advance you 90% of the invoice’s face value.
The account debtor is now instructed to remit payment to the factoring company, not your small business. When the account debtor eventually pays the invoice, the remaining 10% balance is refunded to you, less a factoring fee of usually around 2%.
In this example, the transaction provided an advance that kept operations running smoothly. When the invoice was eventually paid, your business collected a total of 98% of the original invoiced amount, while greatly improving cash flow. Cash flow is the lifeblood of small business.
Who is Factoring Invoices?
Invoice factoring, also known as accounts receivable factoring, is typically utilized by those in the B2B space. It’s common among industries that offer credit sales or endure lengthy delivery or project completion times. Construction, transportation, staffing, food and beverage distributors, commercial cleaning businesses, government contractors and import-export businesses routinely factor.
However, as technology has caught up to this historic financing method, new industries have started factoring receivables. These include medical billers, professional services (accountants and consultants) and even freelancers. As the gig economy expands, the market for freelance factoring is an exciting prospect.
The internet has improved the factoring industry as a whole, decreasing overall costs for users. Greater transparency and availability of information has reduced credit service and other due diligence costs- while the electronic payment revolution has made funding faster and cheaper. Further, many businesses get invoices funded directly with one click via their QuickBooks or FreshBooks accounting software.
We offer a list of invoice factoring companies including Bluevine, Fundbox, Fleet One factoring, Riviera Finance, OTR Capital and Apex Factoring). You’ll notice that some of these are trucking factoring companies (given the nature of their payment cycle), while others are gravitating more online.
Benefits of Invoice Factoring
Immediate Cash Flow
Adequate cash flow is critical to business. In fact, 82% of small business failures are the result of poor cash flow management according to a U.S. Bank study. Factoring provides quick funding, often same day, that can be used to meet short term liabilities and improve net working capital. It benefits the bottom line as businesses can capitalize on supplier discounts by ordering in bulk or pre-paying.
With factoring, this initially funding comes through the “advance”. The invoice factoring company will assess the financial health of your customer and decide on an amount, typically between 75% and 90% of the invoice’s face value. Some will advance a full 100% of the face value as we point out in our Fundbox reviews page.
Funding without Debt
Factoring is not a loan- it’s the sale of accounts receivable to a third party. As such, the funding comes without additional indebtedness. It is a great small business funding option when credit conditions tighten.
The reason many small businesses pursue alternative financing in the first place is because they’ve been turned away by traditional banks due to bad business credit. But it’s the creditworthiness of your customer that matters to the factor, since they collect from them, not you. Invoice factoring provides collections services so you can get back to running your core business.
Conversely, invoice financing is a revolving line of credit. Here, the invoices are used as collateral for financing, making it one of our favorite bad credit business loans. Secured financing generally offers lower rates than unsecured forms, like small business credit cards.
Credit Risk Management
In a non recourse factoring transaction, the factor assumes the credit risk of the account debtor. This essentially transfers the credit risk onto the factoring company. While adding the “non-recourse” clause is slightly more expensive, it’s a valuable risk management tool if you have a high concentration of receivables with one customer. (where their default could jeopardize your operations). It does not protect if they won’t pay because of a defective or late shipment or dispute over other terms.