small business invoice factoring

Understanding Small Business Invoice Factoring

Ezra Cabrera | September 16, 2021


    Key Takeaways

    • Factoring is when a business (typically a B2B one) sells its accounts receivable invoices to a third-party financier.
    • Invoice factoring pertains to the purchase of invoices, as these are considered part of a business’s assets. This is why factoring isn’t considered a loan, and businesses don’t incur any debt.
    • Small businesses may turn to invoice factoring to fund business operations. It also leads to more working capital or additional funds for business expansion.

    Understanding Small Business Invoice Factoring

    Can a business owner turn unpaid client bills into cash on hand? The quick answer is yes. This can be done through invoice factoring.

    This financing solution can be beneficial for any B2B business, or those that have other businesses as clients. If a client fails to pay you on time, or in a timely manner, it can cause your company to experience disruptive cash flow gaps.

    Invoice factoring allows you to fill those gaps in your accounts receivable so you’re able to continue paying your staff and maintaining operations.

    Here’s everything that a small business owner needs to know about factoring invoices.

    Invoice Factoring: An Overview

    When businesses sell their unpaid invoices to an invoice factoring company, the factoring company collects money directly from the business’s clients. The business will most likely receive 60-95% of the invoice value, rather than the whole amount.

    What business owners should know is that invoice factoring is not a loan – at least not in the traditional sense. Instead, a business sells its invoices to a factoring business at a discount, in exchange for quick access to a lump sum. The bills and receivables then become owned by the factoring company, which is paid when it collects from the business’s clients. This usually takes 30 to 90 days.

    The simplest way to put it is this: factoring is the sale of a company’s accounts receivable invoices on credit terms to a third-party financier.

    Who Benefits from Factoring?

    Since factoring companies will buy these invoices at a much lesser price than the original amount, they earn additional revenue. Others instead will charge additional fees.

    However, business owners can also greatly benefit from factoring. When a business runs out of cash or needs to pay off debt, it may opt to sell its invoices to receive additional funds. Though it’s understandable that the vast majority of business owners don’t want to be in this position, this can still be a very efficient way to boost cash flow within a short amount of time.

    How Does Invoice Factoring Work?

    It’s good for business owners to gain a better understanding of how factoring works and how a factoring company operates.

    Here’s a breakdown of how the process works. A factoring company will advance a small business up to 90% of its invoice’s total value, and the 10% may be seen as payment for processing the outstanding invoices.

    The factoring company will then be in charge of collecting the total amount from the end client. If the factoring company charges additional fees, then it may give the remaining ten percent to the business after the invoice has been settled and all fees have been paid. The factoring fee that is normally charged may vary, but the range is typically from 1% to 5% of the entire amount or invoice value.

    This is why factoring companies differ from traditional lenders. Factoring is not a loan, despite the fact that both factoring and lending can advance payments to small businesses.

    Factoring companies merely purchase invoices, usually at a lesser price. This is fine, as invoices are also considered part of a business’s assets. Due to this, businesses don’t have to worry about getting into debt, and their credit scores won’t suffer as a result.

    However, business owners should be aware that factoring rates are influenced by a number of other factors, like the length of the invoice term. For invoices with overdue or extended payment terms, even higher fees may be charged. This is because factoring companies also assess the time it will take for their investment to pay off.

    The Benefits and Advantages of Small Business Invoice Factoring

    Small and medium-sized businesses (SMEs) should be aware that each factoring company operates under its own set of rules. Depending on how they handle their internal operations, their terms and conditions may differ. Some companies, for example, may pay invoice sellers within 24 hours of receiving the invoice. Others could take several days to process.

    However, there are still many benefits that invoice factoring can provide to small and medium businesses. Here are some of them:

    Access to Fast Cash

    It provides instant capital. Business owners don’t need to wait for clients to settle their accounts as invoice factoring can help quickly overcome financial gaps caused by slow-paying clients.

    Stronger Cash Flows

    A business may keep its most loyal clients on longer payment terms while maintaining a strong cash flow. This allows the business to scale.

    Easy Approval

    It’s much easier to obtain invoice factoring services, as compared to traditional loans. This is because invoice factoring companies don’t ask for collateral, and they’ll also provide funds to those with a low credit score or a limited operating history.

    Factoring companies are typically solely interested in the value of the invoices a business wants to sell. They’re also more interested in the creditworthiness of the business’ clients than that of the business itself.

    Better Than Many Loan Types

    Invoice factoring can provide additional capital to businesses that might not be able to receive it from other sources, such as a traditional bank. Invoice factoring is an unsecured loan, which means that business owners don’t have to put up any collateral that the lender can seize if the business owner defaults on the loan.

    However, there are still disadvantages to invoice factoring. Here are some of them:

    It Can Be Expensive

    The service might be quite costly. Aside from the factoring fees, other hidden charges could include application fees, processing fees for each invoice financed, credit check fees, or late fees if a client is past due on a payment. These must all be carefully considered. For example, late payments can result in an increase in a borrower’s annual percentage rate, which is the total cost of borrowing money each year, including all fees and interest.

    Not for All Types of Businesses

    Since invoices are involved in transactions, invoice factoring is most appropriate for businesses that work with other businesses (B2B). As a result, businesses that sell to or work with consumers directly (D2C) may not be eligible for it.

    Lack of Direct Control

    Invoice factoring companies are the ones that will directly collect invoice payments. This means that businesses must ensure that the factoring company they partner with will maintain good relationships with the customers.

    It Rests on the Clients’ Creditworthiness

    Clients with poor credit scores or who can’t manage their finances can cause factoring companies to reject a business’s application. This is because the customers’ creditworthiness may be checked or evaluated by the factoring company.

    No Guarantees

    Business owners should know that there is no guarantee that they will be paid. This is because there’s no guarantee that the invoice factoring company will be able to successfully collect all overdue invoices. If the factoring company is unable to do so, the business may be asked to buy back the unpaid invoice. They may also be asked to replace it with an invoice of equal or larger value instead.

    Finding the Right Factoring Company for Your Business

    Factoring companies may operate very differently from one another. This is because some may choose to focus on a specific niche and, as a result, may opt to use specific language or position themselves in a certain way.

    However, a business owner may be able to narrow down his or her search for the best factoring company to engage with by asking certain questions. The first question they should ask is how long the factoring company has been in business. Working with a more established company might make a business owner feel more at ease. The factoring company may be able to manage its resources more effectively while also establishing excellent working connections with the clients.

    Business owners should also consider the factoring company’s terms, fees, and funding limits since all of these aspects will influence whether or not to go for the factoring service. Furthermore, business owners must consider how invoices will be funded, as well as how the payments will be sent.

    It’s also a good idea to find out how the factoring company acquires its funds. Some may partner with more established financial institutions. However, others may also obtain the services of middlemen.

    Another thing that small business owners should consider is how the factoring company interacts with the clients with outstanding invoices. This is crucial since the last thing the business owners want to do is endanger their existing client relationships.

    When it comes to choosing which factoring companies that small business owners should trust and which ones they should avoid, there are no hard and fast rules. However, there are several red flags to watch out for. Small business owners should avoid factoring organizations that try to include a lot of hidden charges into the contract.

    Also, if a business owner becomes concerned, at any point, about how the factoring company would represent them, the partnership with the company should be reconsidered. Especially when the concern pertains to how the factoring company may approach clients to collect unpaid invoices.

    However, there are still many other ways for business owners to assess whether or not they should partner with a factoring company. Reading online reviews is one. Generally, a large number of continuously bad reviews is always a warning sign. Additionally, contacting people who have previously worked with a certain factoring company is always a good idea.

    Final Thoughts

    Invoice factoring allows business owners to swiftly access funds from pending invoices. The money can then be used for business operations, as well as efforts to expand or scale.

    Invoice factoring put simply, is when a business sells its accounts receivable to a factoring company in exchange for cash, upfront. When a business opts for invoice factoring, it is first paid by a factoring company, who is then paid directly by the business’s client.

    This means that instead of waiting up to 90 days for clients to pay, a business may turn its accounts receivable into cash. A factoring company usually advances a small business up to 90% of the total invoice value. The remaining 10% may be regarded as payment for processing the outstanding invoices, unless the factoring company opts to charge factoring fees, instead.

    The factoring company will then be in charge of collecting the total amount from the end client. If the factoring company charges additional fees, then it may give the remaining ten percent to the business after the invoice has been settled and all fees have been paid. The factoring fee that is normally charged may vary, but the range is typically from 1% to 5% of the entire amount or invoice value.

    Though it may provide many benefits, factoring is still regarded as a relatively expensive form of financing. The good thing, though, is that it can help a business improve its cash flow without incurring any debt.

    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.