Invoice Factoring 101: Everything You Need to Know About Small Business Factoring

Ezra Cabrera | January 25, 2022


    Until now, cash flow issues remain a huge concern among small business owners. Small businesses and startup companies are familiar with the hardships of securing a bank loan. Banks and traditional lenders need a business’ proof of viability and they are reluctant to lend money to companies without enough credit rating, income, and the number of years in business.

    To increase your chances of approval, you need to be operational for a few years, establish a strong credit rating, and maintain positive cash flow. These prerequisites leave business owners with a few loan options to choose from. Fortunately, there is one financing option that most business owners don’t know about – small business invoice factoring.

    What is Invoice Factoring?

    Small business owners need working capital to keep up with the ever-changing market. However, some companies don’t have enough to even cover day-to-day expenses. If you need fast cash and you have several pending accounts receivables (invoices), you might want to consider business invoice factoring.

    Invoice factoring lets business owners sell pending invoices to lending companies in exchange for fast cash. Lenders often fund 80% to 90% of the total invoice value, while the remaining balance (minus a factoring fee) will be given to you once your customers pay their dues.

    For example, if your invoices are worth $100,000, you may receive $90,000 upfront. The lending company may hold a percentage of the invoice value until your customers pay their invoices. Once the invoices are fully paid, they’ll send you the remaining amount of money minus the fees.

    To further understand invoice factoring, how accounts receivables work, as well as the role of factoring companies, the following insights will help you understand the process.

    Accounts Receivables

    An invoice, also known as accounts receivable, is the money owed to your business after delivering goods or rendering services to your clients. Once the sale is made, you can send an invoice to your customers indicating the terms for payment.

    The invoice term usually lasts from 30 to 90 days. At the end of the term, your customer should pay the amount they owe. However, small businesses don’t often have the luxury to wait for a month or two to get paid. As long as your business is operational, business expenses will keep on coming. Factoring for small businesses lets you sell those pending invoices in exchange for upfront cash.

    For small business owners, your invoices are as good as cash. It’s an immediate cash resource you can tap into. Once you’ve sold the invoice to your chosen lender, you can immediately use the money for daily business expenses rather than wait for months.

    Factoring Companies

    A factoring company is a third-party lending institution that purchases invoices at a discount. Before you proceed, do know that your customers will know if you’ve taken on invoice factoring. Instead of paying directly to you, they will be remitting payment to the lending company you’re working with.

    Before purchasing your invoices, factoring companies consider the following:

    1. Your business and personal credit history. Although your customers’ credit rating weighs heavier, lenders still need to conduct due diligence.
    2. The next thing they’re going to look at is your customers’ credit scores. They need to ensure that they are financially reliable to pay for the invoices. You can determine whether your customers are creditworthy by evaluating them.
      • Do they usually pay on time?
      • Do they have great credit scores and payment histories?
      • What industry do they operate in?
      • Do they have any debt or legal issues that may hinder them from paying for invoices in the long run?
    3. Another thing they need to consider is the number of years you have been doing business with your customers.

    The rule of thumb is that if you have a strong credit rating and a stable relationship with creditworthy clients, lenders will most likely consider you low risk and grant you more favorable terms. The higher the risk, the higher the interest rates factoring companies will charge.

    The Benefits of Small Business Factoring

    The most noteworthy benefit of invoice factoring is that it’s not your typical business loan. In fact, it’s technically not a business loan at all! With invoice factoring, you are receiving an advance of the money you are already owed.

    Other benefits of small business factoring include the following:

    1. Acquire Working Capital without Incurring Debt

    For many business owners, the first thing they do if they need extra cash is to take out a business loan. However, taking on new debt may not be a good idea, especially if your business is already struggling to make ends meet.

    While borrowing money can be helpful at times, most business owners would prefer to acquire working capital without incurring debt. Factoring for small businesses allows you to leverage pending invoices in exchange for fast cash.

    2. Quick Turnaround

    Most small business owners know all too well that the underwriting process for traditional business loans takes weeks or months. If you need quick access to capital, you can’t wait that long to receive funding.

    Once your transaction is approved, it will only take 24 to 48 hours before you receive the much-needed cash. Whether you need to pay your suppliers, make payroll, or get your business through a seasonal slump, small business invoice factoring can help.

    However, keep in mind that if it’s your first time transacting with a lender, you may need to wait for about a week before you can receive the money. After the initial transaction, factoring your invoices will be easier and faster.

    3. Better Chance of Approval

    When you apply for traditional loans, lenders will assess your credit scores, collateral, and loan history. But with business invoice factoring, these factors won’t matter as much. As mentioned, factoring companies rely heavily on your customers’ payment histories and creditworthiness.

    This gives them an idea of the level of risk they’re going to take if they decide to approve your application. If your credit score is less than ideal or if you don’t have enough assets to qualify for traditional loans, try invoice factoring.

    Invoice Factoring: Why Your Customers Will Love It

    Despite the many benefits of invoice factoring, there are still business owners who are hesitant to try it. Mainly because they’re concerned with their reputation as a business, as well as the impact it will have on customer relationships.

    Some business owners think that if they sell their invoices to factoring companies, their customers and suppliers may think that their business is not doing well. Another concern is that factoring invoices may be detrimental to customer relationships because it becomes the factoring company’s job follow up on payments.

    But contrary to popular belief, invoice factoring will not only benefit your company, but it will also improve relationships with your customers. Here are three reasons why:

    1. Streamline the Accounts Receivable Process

    Let’s face it – nobody likes to follow up on payments. Payment collection can be a hassle, especially if you handle a lot of invoices. By using small business factoring, the task of collecting payments is done by the factoring company. Your customers will directly pay their dues to the factoring company, instead of paying you. In this way, you can free up your time and focus on growing your business while securing the working capital you need.

    2. Payment Collection Process Handled by Professionals

    Factoring companies want your customers to pay their invoices as much as you do. It’s a common misconception that lenders will chase and harass your customers for payments. Lending companies assign well-trained employees to track and follow up on payments.

    If you’re working with an experienced and reliable factoring company, you don’t have to worry about invoice payments because reputable factoring companies are known for providing professional payment collection methods.

    It’s also worth knowing that factoring companies are not competing with you, nor do they want to compete with you. Renowned factoring companies genuinely want to see your business succeed. They know that without your customers, you won’t have a business, and neither will they.

    This is why factoring companies will go the extra mile to ensure that your customers are dealt with respectfully and professionally. However, keep in mind that it’s your responsibility to look for an experienced factoring company.

    3. Boost Your Company’s Growth

    The growth of your business benefits your clients. With invoice factoring, your business will have a steady influx of working capital. In addition, it lets your customers know you have a financial cushion and that your finances are under control. This improves your reputation in the eyes of your clients and suppliers.

    Having quick access to working capital, this demonstrates that you have enough funds for day-to-day operations and business expansions. Clients and suppliers prefer to work with successful businesses, that’s why it’s best to keep your cash flow in check.

    Should Your Business Apply for Invoice Factoring?

    Most business owners mainly use invoice factoring to secure working capital without taking on debt. But how do you know if invoice factoring is right for your business? Here are some of the main factors you need to consider:

    • Creditworthiness and reliability of your customers
    • Your business and personal credit rating (Unlike traditional loans, you can qualify for invoice factoring even if you have poor credit.)
    • The number of pending invoices and their corresponding amounts

    It goes without saying that not every financing solution works well for small businesses. While invoice factoring may be great for some, it doesn’t mean it’s going to work for you.

    Remember to take the time to explore different types of business loan options before making a commitment.

    About the Author

    Ezra Neiel Cabrera has a bachelor’s degree in Business Administration with a major in Entrepreneurial Marketing. Over the last 3 years, she has been writing business-centric articles to help small business owners grow and expand. Ezra mainly writes for SMB Compass, but you can find some of her work in All Business, Small Biz Daily, LaunchHouse, Marketing2Business, and Clutch, among others. When she’s not writing, you’ll find her in bed eating cookies and binge-watching Netflix.