A Basic Introduction to Invoice Factoring
Invoice factoring is a legitimate way for B2B businesses to maintain a consistent cash flow. However, many businesses do not know where to start their search for a factoring company that will fit their needs.
Are you trying to choose a factoring company? Here’s everything you need to know.
Table of Contents
- Why Factor Invoices?
- What Is Invoice Factoring?
- How Much Does Factoring Cost?
- Terms & Conditions
- Alternatives To Factoring
- Final Thoughts
Why Factor Invoices?
Quite simply, many merchants employ factoring to keep their businesses running smoothly. If your business operations are impacted by a shortage of cash because your clients take too long to pay their invoices, factoring may be for you.
Businesses in many B2B industries use factoring. Common industries that use factoring include transportation, government contractors, staffing companies, advertisers and media companies, and any other business that invoices customers.
What Is Invoice Factoring?
Invoice factoring is simple. Businesses sell their invoices, at a discount, to factoring companies in exchange for cash up-front.
To negate against risk, the factor will hold a small reserve of 5% – 30% of the invoice value until your customer has paid. The fee for factoring, called the discount rate, and any chargebacks or refunds will come from this reserve.
A typical factoring interaction might look like this: you sell an unpaid invoice with a value of $10,000 to a factor. The company advances you 85% (or $8,500) of the cost up-front, and holds 15% (or $1,500) in reserve. When your customer pays, the factor will send you the reserve, minus a small fee.
Recourse vs. Non-Recourse
In general, there are two types of factoring—recourse and non-recourse. The difference determines who is responsible if the customer does not pay their invoice.
With recourse factoring, the more common type, you are responsible for paying the bill if your customer cannot or will not pay. Because this arrangement is not as risky for the factor, they’ll normally charge smaller fees. However, an unpaid invoice can present a problem for your business if you do not have the means to cover the costs.
Non-recourse factoring, of course, works differently; if your customer does not pay, your factor must simply write off the debt. Non-recourse factoring tends to be more expensive because of the additional risk.
How Much Does Factoring Cost?
Factors charge a discount rate when you sell an invoice. Many also charge other fees for certain services. Here is what to expect:
The discount rate is normally between 1% – 6% per month. Depending on the factor, the rate might accrue on a daily, weekly, or monthly basis. Your fee will be deducted from your reserve (the amount of the invoice that the factor holds back). The longer your customers take to pay, the larger the fee will be.
Your fee is dependent on how risky the factor perceives the transaction to be. If your customers are not creditworthy or your business is in a risky industry you might have higher fees.
For example, if you have a fee of 4% on an invoice worth $1,000 and your customer takes 60 days to pay, you will have a fee of about $80. If your customer takes 90 days, your fee will be about $120.
In addition to the discount rate, your factor may charge fees for application, maintenance, or other reasons. Here are common fees you may encounter:
- Application fee
- Diligence fee
- Maintenance fee
- Lockbox fee
- Wire fee
- Early termination fee
- Cancellation fee
Terms & Conditions
There are a number of terms and conditions you must consider to find a factor that will work for your business.
Contract Length & Termination Notice
Contract length and termination notices vary between factors. Some require long-term contracts and charge fees for canceling before the contract is up. Others may simply require advanced termination notice.
Which Invoices Are Factored
Most companies will let you choose which invoices you decide to sell (as long as the invoice is from an approved customer), but some will require that you sell all invoices from specific customers or all your invoices period.
Monthly Minimums & Maximums
Some factors will require you to sell a certain amount of invoices to them each month, or conversely, may cap the amount that you’re allowed to sell.
Notification vs. Non-Notification
For whatever reason, your business may need to keep your factoring arrangement discreet. If so, you may be able to set up a non-notification agreement, which means that your customers do not know that you have sold their invoices. On the other hand, notification factoring means that your customers are aware of the arrangement.
Alternatives To Factoring
Invoice factoring can help a lot of businesses solve cash flow problems. However, if you don’t think it’s quite right for your business, but you still process invoices, you may have other options:
Asset-Backed Lines Of Credit
Instead of selling your invoices, lenders that provide asset-backed lines of credit simply use them as collateral.
Asset-backed lines of credit operate like traditional lines of credit—you are granted a credit facility from which you can draw anytime, and you only pay interest on the amount borrowed. Because you know how long repayment will take, you know exactly how much you’re paying for the capital.
Non-Traditional Invoice Financing
Invoice factoring has existed in some form or another since the time of ancient Mesopotamia. In recent years, however, some companies have been overhauling traditional factoring.
Companies that offer non-traditional invoice financing services aim to make it as easy as possible for B2B businesses to get affordable financing. Most have eliminated complicated terms and conditions in favor of granting businesses maximum flexibility. These companies normally have higher fees than traditional factors, though.
Because eligibility for invoice factoring is contingent on the creditworthiness of your customers (and not the health of your business), invoice factoring is a relatively cheap source of financing that will work for a lot of businesses.
Above all, look for a factoring company you trust, and one whose terms and conditions will work for your business. Good luck!