Invoice factoring is a way for businesses to fund cash flow by selling their unpaid invoices to a third party (a “factor” or “factoring company”) at a discount in exchange for cash upfront. Let’s review the pros and cons to consider before deciding whether invoice factoring is the best funding option for your small business.
PROS OF INVOICE FACTORING
The biggest benefit of invoice factoring for small businesses is that you can receive the money owed to your business without having to wait for customers to pay you back. Here are five other common advantages to invoice factoring:
1, Immediate Cash Flow
When applying for a bank loan, it can take months for you to be approved. Then, it can take additional time to actually receive the financing once you receive your approval status.
In comparison, invoice factoring gives you access to cash quickly (in some cases, you can get same-day funding), so you can keep your business running smoothly. This is an especially viable option if your business is in the following situations:
- You have short-term financing needs
- You have an emergency need and can’t afford to wait weeks or months to get approved
- You don’t want to wait for your customers to pay you back
2. Ongoing Cash Flow
Invoice factoring doesn’t need to be a one-time financing option. You can build a relationship with your factoring company that will continue if it makes sense for your business. Maintaining cash flow won’t be a problem because you won’t have to wait for invoices to be paid before you have money in your bank account each month.
3. Higher Chance of Getting Approved
Collateral, credit score and loan history aren’t major factors in determining your ability to use invoice factoring. Typically, the factoring company will be most concerned with looking at the payment history of your customers because this indicates what kind of risk they’re taking on. Therefore, if your credit score is low or your financial history includes other red flags, invoice factoring still might be a feasible option.
4. Ability to Outsource
Keeping track of outstanding invoices and contacting customers can be very time-consuming. So delegating those tasks to another company could free up your resources. You’ll have more time during the business day to deal with other responsibilities while the factoring company does the customer calls and sets terms for payment.
5. No Collateral Required
Invoice factoring is unsecured financing, which means it doesn’t require collateral. The invoices themselves act as collateral, so you don’t have to worry about submitting real estate, equipment or other larger forms of collateral.
CONS OF INVOICE FACTORING
The fees associated with this type of financing can be limiting. Typically, a factoring company will charge between 1 and 5 percent of the total invoice amount in service fees. Due to this cost, you’ll need to decide if the tradeoff for immediate cash is worth the income loss.
If your business is on a tight budget, it might make sense to wait for customer payments instead of selling your bills to an invoice factoring firm at an additional cost. Here are three other common disadvantages to invoice factoring for small businesses:
It’s important to know that you may be responsible for unpaid invoices. Invoice factoring companies don’t act as collections agencies, and they most likely won’t take extra time to track down late-paying customers.
If you have a recourse invoice factoring agreement, you’ll be responsible for paying for those unpaid invoices or trading in a different invoice of the same amount to cover the cost.
2. Dependency on Customers
When determining eligibility for invoice factoring, the factoring company will look at your customers’ payment history to calculate the risk of taking on your invoices.
If your customers have a habit of not paying you on time, the factoring company will assume they won’t be paid on time, either. Due to this, they’ll be less likely to take on your invoices because it may be too much risk.
3. Lack of Control
Invoice factoring involves handing over complete control of your invoices to another company. Some business owners don’t like this because they don’t want another company to have access to their financial information.
Before applying for invoice factoring, you should ensure that you’re comfortable with that company and its financial practices. If you choose a reputable factoring company, you should be confident that the process will go smoothly.
Tips to Consider Before Hiring an Invoice Factoring Company
We’ve all been there at one time or another—short on cash, needing extra capital for whatever reason, and yet our clients are slow in remitting their payments. This can be very frustrating, especially if you’ve earmarked that money for a specific purpose. And now your bottom line is affected because the customer just hasn’t made good on that invoice.
Pressing the client to pay you could hurt your working relationship. Then again, depending on how old the debt is, it may be worth risking that relationship if, in fact, that money is very slow in coming. Another option, of course, is invoice factoring.
With certain factoring companies, you may even be able to get your funds in as little as one day. Not to mention, you are no longer responsible for chasing after that client to get the money due to you. The companies do the leg work, they track the invoice, and they, in turn, take their fee.
Depending on the type of agreement in place (recourse versus non-recourse), if the customer never pays, it could be the factoring company that takes the hit without your business being penalized. Carefully read and review the terms and conditions before signing any such agreement.