Waiting on customers to pay their invoices off can have a snowball effect on your company's finances, holding you up from making essential payments on payroll, utilities, inventory, etc. Along with a disruption to day-to-day operations, unpaid invoices can also prevent you from investing in new business growth opportunities or taking on more jobs. To keep things moving smoothly, invoice factoring can alleviate the stress of that cash crunch and help you maintain success.
What is invoice factoring?
Invoice factoring is a type of financing where you sell your unpaid customer’s invoices to a factoring company in exchange for immediate cash upfront. Invoice factoring is considered a sale, not a loan, so it never affects your credit score and is an ideal option for small business owners to get the money they need rather than waiting on customers to pay off their remaining balance.
How does invoice factoring work?
- Once a business owner provides goods or services, the invoice is sent to the customer.
- The invoice is also sent to the factoring company.
- Depending on the factoring agreement, the business owner will receive a cash advance for approximately 80-90% of the invoice amount.
- The factoring company is now responsible for collecting payment from the customer.
- Once the invoice is paid, the factoring company will release the remaining 10-20% of the invoice to the business owner, minus a factoring fee.
Let’s say you own an HVAC company and just installed two new AC units for a local retail store, creating a $10,000 invoice which your customer agrees to pay off within 30 days. Since you need the cash immediately to start on your next job, your invoice factoring company buys the invoice off for $9500 cash with a 5% factoring fee ($500). The invoice factoring company advances 80% of the invoice ($7,600) so you can have cash in a few business days. 30 days later, they collect the invoice from your customer and pay you the remaining balance ($1,900).
Terms to look out for:
- Approval period - The agreed-upon period of time that the customer will pay off their invoice. Any unpaid debt will be recoursed back to the business owner, sometimes along with refactoring fees.
- CHOCC factoring - CHOCC stands for Client Handles Own Credit Control, and the business owner is responsible for collecting payment rather than the factoring company.
- Confidential factoring - Keeps the factoring company completely confidential from the customer who owes the invoice.
- Disbursements - Additional fees charged by the invoice factoring company, such as credit checks, admin errors, receiving letters, expedited bank payments, etc.
- Disclosed factoring - The customers are made aware that they are dealing with an invoice factoring company.
- Non-recourse factoring - If the customer fails to make the invoice payment, then the factoring company will take responsibility for the loss, not you. This creates a lower risk for the business owner but typically comes with a higher factoring fee.
- Payment terms - Refers to the agreed timeframe that the customer has to pay off their invoice. The most common payment terms are 30, 60, and 90 days but this can vary depending on the factoring company and customer’s contract.
- Selective factoring - A type of invoice factoring where they bundle smaller amounts together or are individual rather than a large amount or the entire sales ledger.
- Spot factoring - This allows you to factor invoices individually.
Pros and cons of invoice factoring
Every business owner should thoroughly understand the role that invoice factoring can play in their financial journey and make a decision that will best suit their needs. Like any financial business decision, invoice factoring has pros and cons and can vary depending on the business itself. Here are a few pros and cons to invoice factoring to help you weigh your options.
Pros of invoice factoring
- Quicker and cheaper - Invoice factoring is much cheaper than taking out a bank loan. They’re also faster to obtain, making them ideal for short-term funding.
- Reduces stress and burden - Hiring an invoice factoring company can reduce the workload put on your own employees. Instead of wasting valuable company time chasing invoice payments down, they can remain focused on the work you need them to do while the factoring company takes matters into their own hands.
- Predictable cash flow - Invoice factoring pays the invoices off that are weighing you down and preventing money from coming in, making it easier to plan and predict for the next business opportunity and have the finances to back up your decisions.
- Strengthens your business - Without adequate cash flow, many businesses fail. Invoice factoring helps to alleviate financial pressures and issues so you can continue to operate without interruption and build a stronger, more dependable company.
Cons of invoice factoring
- Recourse can be costly - Depending on your budget and the reliability of your customers, recoursing and refactoring fees could add up. If you know your customers well enough to know they have a history of not paying back invoices, this might not be the right option. There’s always non-recourse factoring as well, but, once again, it tends to cost more out the gate.
- Additional fees - Invoice factoring companies typically charge additional fees for various services, including wire transfers, returned checks, late collections, etc. It’s essential that you understand your company’s budget and if a factoring company will fit your needs.
- It takes commitment - Invoice factoring contracts don’t typically let you switch the services on and off frequently; it’s a long commitment. Every customer’s contract is different, but factoring companies will want to help you manage the bulk of your invoices rather than a few here or there despite spot or selective factoring options. Make sure that the length of your contract is fit for your company before committing.
Most invoice factoring companies are industry specific, which is important to take into consideration when searching for a company that’s right for you.
Invoice factoring vs. invoice financing
Although they sound similar, invoice factoring and invoice financing are two separate things that differ based on who is ultimately collecting payment on your invoices. With invoice factoring, the factoring company will remain in control of collecting the payments on the invoices they’ve purchased, whereas, with invoice financing, you retain control of collecting payments. Your business's creditworthiness is also a significant consideration with invoice financing; with invoice factoring, your client’s credit is the priority. Additionally, invoice factoring and financing differ when it comes to borrowing. Invoice financing typically needs you to repay your loans before borrowing again, while with invoice factoring you can factor approved invoices sent to clients regardless of your unpaid loans.
Choosing an invoice factoring company
Most invoice factoring companies are industry specific, which is important to take into consideration when searching for a company that’s right for you. A factoring company that understands your company's needs will ultimately be beneficial to your success in the long run and will help make the process seamless. It's also important to consider interest and advance rates when choosing a factoring company. Lower interest rates will help you with your budget, and high advance rates will allow access to more of your money upfront. When budgeting, you should also get all the information about potential additional fees before signing a contract to prevent sticker shock when paying your factoring company.
Business owners also have to choose between an independent company or a bank. Independent companies understand that you need to increase cash flow and will consider taking you on as a client even if a bank has turned you down. You may still qualify for factoring if you have creditworthy customers. Banks offer the same flexibility as independent companies but may not have industry-specific knowledge and services. On the other hand, banks have their own source of funds, making it easier for them to offer competitive rates.
Invoice factoring is a great financing option for business owners in the contracting industry. Instead of waiting around for cash, it allows you to start working on new projects and increasing revenue. Although it has its advantages, it’s not always for everyone. It’s essential to know and understand your business needs thoroughly, budget, and flexibility for invoice factoring to work efficiently. Before jumping head first and committing to an invoice factoring company, ensure you understand what type of contract and terms work best for your company. If done correctly, it can help expedite new projects and sources of income to continue growing and expanding your company.