Factoring Invoices Pros and Cons: An In-Depth Look at the Mechanics of Invoice Factoring
Ezra Cabrera | August 19, 2022
Invoice factoring is a type of financing that allows entrepreneurs to advance cash against the value of their accounts receivables. In other words, you take out a loan ahead of the cash that you're yet to collect from your customers or debtors.Let's define invoice factoring, how it works, and the different factoring invoices pros and cons.
What is Invoice Factoring?
With invoice financing, borrowers can sell pending receivables to a third-party company. Lenders can advance up to 85% to 90% of the total invoice value upfront, so you don't have to wait for months to receive payment. You'll be able to use the funds for any business purpose, such as buying inventory, equipment, and machinery, and more.For example, Company A looked at its financial statements and realized that it needed about $50,000 to pay pending employees' salaries. The company discovered that it had $55,000 of debt left to collect from its clients.Company A considers selling their invoices and forwards a cash advance worth 80% of the invoices' total value, with a factoring rate of 5%. Company A turns over the invoices to the lender and receives the cash upfront. The lender will then collect invoice payments from your customers, while Company A uses the money to grow the business.
Invoice Factoring Fees
Lenders may charge fees on top of the You may find yourself paying other fees when factoring your invoices. These are some of the additional fees that the invoice factoring company may charge you:New account fee: Some invoice factoring companies may ask you to pay a fee for opening an account with them.Credit check fees: As mentioned earlier, invoice factoring companies have an interest on your debtors' ability to repay their debts with you. They may do a credit check on some of your clients, which you might have to pay for.Wire fees: You may have to pay wire transfers if your factor company sends or receives money through electronic banking.Lockbox fees: Lockbox banking is a custodial service. Your factor company will hold on to your clients' payments until collection is complete. It may charge your business a fee for keeping your money on your behalf.Overdue fees: You may be charged a fee for every client that is late with their payments. In some cases, the factor will combine all late clients and charge a single fee for all of them.Renewal fees: You could expect to pay annual renewal fees if you have an ongoing arrangement with your factor that goes beyond a single transaction.Be sure to ask potential lenders about the fees they're going to charge. Reputable lending companies are transparent about rates and fees. If they hesitate to disclose this, it might be best to look for another lender.
The Pros and Cons of Invoice Factoring
Another important factor to consider before applying is the pros and cons of invoice factoring. Weighing your options allows you to make better financial decisions for your company.
Pros of Invoice Factoring
- Ongoing cash flow. Factoring your invoices doesn't have to be a one-time transaction. The key is to build a relationship with your factoring company and continue factoring your invoices with them if it makes sense for your business. As a result, maintaining a positive cash flow wouldn't be a problem.
- Immediate access to working capital. Small business owners know the struggle of applying for a bank loan. It usually takes months before you're approved of a loan and a few more weeks to receive the funding you're qualified for. On the other hand, invoice factoring provides you with the cash you need within 24 to 48 hours. This is especially beneficial for businesses that need to address short-term financing needs.
- Higher chances of approval. Unlike traditional loans, collateral, credit score, and financial history are not major determining factors to qualify for invoice factoring. Lenders are typically more concerned about your customers' creditworthiness since they're the ones paying for the invoices. So, you might still qualify for invoice factoring even if your credit score is low or you're new in the business.
- No need for collateral. You don't need to submit your property, equipment, or other forms of collateral to secure the loan. With invoice factoring, the invoices themselves serve as collateral.
- Improve relationships with your customers. Debt collection can be frustrating for you and your clients. When you factor in your invoices, your lender will be the one to collect the payments from your customers. Without you directly collecting the money from them, you'll be able to maintain a positive and long-lasting relationship with your clients.
Cons of Invoice Factoring
- Costly rates and fees. . Some lenders charge high rates and fees, which can be limiting to borrowers. Lenders typically charge between 1% to 5% of the total invoice value, plus they may also charge additional fees, as mentioned above. However, this varies from lender to lender, so ask about the rates and fees before committing. You'll need to decide whether the upfront funding is worth the fees.
- Liability for unpaid invoices. Even if your lender handles debt collections, it's important to remember that they're not a collections agency. In other words, it's unlikely that they're going to go the extra mile to track down late-paying clients. Depending on your arrangement with your lender, you might end up paying for unpaid invoices or trading a different invoice of the same value to cover the loss.
- Limited control. With invoice factoring, you hand over complete control of your invoices to a lending company. This doesn't sit well with some business owners as they don't want another company to access their financial information. Before you apply, be sure that you're comfortable with the lender you're working with.
- Dependent on customers. As mentioned, lenders look at your customers' payment and financial history to measure the risk they're going to take. If your clients have a history of late payments, lenders will assume that they're also not going to be paid on time, therefore, denying your application.
Invoice factoring is an excellent cash source for businesses expecting to receive money from pending invoices but would like to get it a little earlier. Invoice factoring lets you take out a cash advance from a factoring company that you can use for more immediate cash flow concerns while your pending invoices are being collected.Invoice factoring, however, is not without its disadvantages. For instance, the service is limited only to businesses issuing invoices to customers instead of upfront cash payments or credit cards. Businesses that extend trade credit, for example, are ideal candidates for invoice factoring.Like all forms of financing, a wise entrepreneur will know to do careful research before choosing which factoring company to partner with. With due diligence, you can find that factoring company with whom your business can have a fruitful financial relationship.