Oftentimes, invoice factoring will be recommended to a business owner who will end up turning down the option because of common misconceptions. The owner will then look for a financing option that may end up hurting them in the long run because of how their business cash flows.
Turning to a loan or line of credit is not always the best option for businesses regardless of how easily they can obtain one. Knowing what factoring is and when to best use it could be the difference between a growing business or one that closes their doors within months.
What Is Invoice Factoring?
Invoice factoring is a financial transaction in which a business sells its outstanding invoices to a factoring company at a discount. Businesses that sell to other businesses (or the government) use factoring to access immediate cash flow. Factoring is available only to B2B (business to business or business to government) companies.
Factoring is also not a loan and does not affect the balance sheet of a business as they are simply selling an asset. Some business owners prefer to use factoring to avoid taking on debt while in a hyper growth period.
Your business sells and delivers product XYZ to Wholesale Inc., issues an invoice for $1,000 and gives the debtor 60 days to pay.
Your business makes an agreement with a factoring company as follows:
80% advance rate
2% discount fee every 30 days
You sell the invoice to the factor and receive an advance of $800.
On day 29 the debtor pays the invoice (usually sending a check to a bank account opened by the factor under your company’s name)
The factoring company receives the payment and deposits it into a reserve account.
The factor takes $20 as a factoring fee, deducts the $800 already advanced to you and wires the remaining amount $180 (sometimes called a rebate) to your company’s bank account.
Advantages and Disadvantages of Using Invoice Factoring
Quick cash flow boost for your business
Your business can give terms to your customers without worries
Low qualification requirements and simple application process
High approval rates
Cash flow without debt
Minimal credit history requirements
Operational support to A/R department
Not accessible to B2C companies (businesses that sell only to consumers)
More expensive than traditional bank financing
Requires ceding some control of customer interactions regarding A/R
Not a solution for delinquent receivables
Liability for non-creditworthy customers (in most cases)
What You Can Expect to Pay for a Factoring Fee
On average, a business can expect to pay anywhere between 1% and 4% of the total amount of the invoice they factored. The factoring rate is dependent upon how much a business intends to factor and the amount of time it takes to collect payment.
Industries Who Most Commonly Use Factoring:
Factoring clients tend to share one or more of the following characteristics:
Insufficient credit history
Troubled past including prior bankruptcies or forbearances
Bank credit denied or maxed out
Negative net worth
Highly leveraged company
There is a misconception that factoring is a ‘last resort’ for a business but in reality most businesses turn to factoring because they are faced with an opportunity to grow faster than what a bank or traditional financing option may allow.
Banks use a business’ history and ability to pay back a loan which it makes it difficult for a young healthy business to grow because of their limited history. Even if the business is approved, its highly unlikely the bank would be willing to provide the amount of working capital the business needs.
For example, a young business showing steady profit and solid financials may qualify for a $50k line of credit however they may need over $100k to meet the needs of their customers. A factor would be willing to provide the availability of working capital the business needs based on its customers credit worthiness rather than the business’ history.
What Will A Business’ Customers Think?
The most common reason businesses refrain from using a factoring company is because they feel using a Factoring company could damage their relationships with customers. The truth is businesses who factor tend to receive positive responses from their customers because it proves they will have the cash flow to grow. Businesses can approach their customers with confidence in being able to take on more work or deliver more product while maintaining the same payment terms.
How Does Factoring Compare to Other Lending Options?
Factoring does allow for more flexibility than other lending options. A factoring company will usually take the accounts receivables as collateral vs a blanket lien on all assets of a business. This allows factoring companies to work alongside banks in the event they have a client who may be struggling to meet its requirements on a current loan or line of credit. For example, a typical loan or line of credit will have covenants that restrict its use for the business. Covenants could include having to pay back a specific amount by a specific time each month. A business who is tight on cash flow may struggle with this and having a factor in place can help the business performing on its loan or line of credit obligations.
A merchant cash advance is often an option a B2B company is looking at when considering working capital options. The issue for the B2B company is it usually receives payments every 30 or 60 days. The merchant cash advance typically debits the business bank account weekly if not daily to pay back the advance. With cash constantly being taken out of the business bank account before payment is deposited, there will inevitably be a gap unless the business is sitting on enough cash to maintain the payments. While the cash advance is quick and easy, it only patches the cash flow gap issue a B2B company faces.
So...Is Invoice Factoring a Good Idea?
The simple answer is yes, it is a good idea for any B2B company in need of quick working capital and sells a product or performs a service with healthy margins on Net 30, 60, or 90-day terms. Instead of waiting on payments from their customers, they can have instant debt-free cash to continue their growth.
Using the previous factoring example, if you did not have a factoring company in place and the same customer you sold to comes back with another large order, how would you fulfill it if you still owed your supplier from the previous order? This is the most common example of when factoring is best used. Businesses use the funds advanced on their invoices to continue fulfilling larger orders or provide more services rather than waiting 30 or 60 days for payments from their customers.
Angelo Standriff and Gateway Commercial Finance have been in the factoring industry for over 20 years. If you would like to speak with a factoring representative directly, reach out to Angelo at Gateway Commercial Finance.