Invoice factoring and accounts receivable (A/R) each play specific roles within a company. Using one doesn’t mean you have to give up the other. Nearly all companies will have an A/R department, but only some will also use invoice factoring.
A/R is the distribution of invoices for merchandise or services rendered. It is a core part of business operations. Because many companies extend credit to customers on terms of 30 to 90 days, they must find a way to pay suppliers with money they haven’t yet collected from customers. Depending on how well A/R is managed, a cash-flow crunch can be created where the company finds itself running out of cash and unable to pay its own expenses. At that point, the company must quickly find a way to replenish the cash-flow shortage.
Invoice factoring can offset cash-flow shortfalls. A company called a “factor” advances a percentage of outstanding invoices to the business, supplying it with much-needed cash. Flush with cash, the business is able to pay suppliers and return to normal operations, but at a cost.
In exchange for payment advances, the factor charges a fee on outstanding invoices. This fee can range from 0.05% up to 5%. Let’s look at an invoice factor example.
Company A has $15,000 in outstanding invoices due in 30 to 60 days. The company is running out of cash and hires a factor at 3.5%. The factor advances 80% of the outstanding invoice value, $12,000, to Company A. Once customers pay their invoices, the remaining $3,000 minus $525 (.035 x $15,000) is paid to Company A.
Similar to applying for a loan, there are qualifications that merchants will need to meet for invoice factoring. Qualifications will vary by factor, but some common criteria are:
- Invoices must be B2B or business-to-government.
- The business must be a certain number of years old.
- A minimum level of monthly revenue is required.
- There can’t be any legal or tax issues with the business.
Unlike a loan, invoice factoring has an easier and quicker qualification process.
If your business is beginning to experience a cash flow shortage and other financing options have been exhausted, it might be time to consider invoice factoring. While it will cost to use a factor, it can keep the business afloat, assuming there isn’t a systemic problem.
If revenues are continually dropping and customers are leaving, the business might be in a downward spiral. In this case, invoice factoring will be only a temporary fix. Unless something else changes to turn the tide of decreasing revenues and fleeing customers, the business may be headed toward bankruptcy. A business in decline may also experience difficulties getting approved by a factor.
While invoice factoring might sound like an option for the desperate, there are reasons to consider it even if the business is thriving. Invoice factoring can eliminate temporary cash flow shortages. Such a scenario can occur in an otherwise healthy business when there is a miscalculation in the budget or days outstanding for invoices. Cash-flow shortages can also occur if there is an odd seasonality event, some customers declare bankruptcy, or perhaps the business has to issue a large number of refunds for a defective product.
Another scenario for which to consider invoice factoring is when more cash is needed than is available for a project. If time is critical for starting a project but cash isn’t there, and other financing options have been exhausted, invoice factoring can bring in cash needed immediately.
One clear advantage that A/R has over invoice factoring is that you don’t have to give up control. With invoice factoring, the factor takes over and handles payment collections, directly interacting with customers. It’s a good idea to let customers know that they’ll need to start sending invoice payments to a different company (the factor).
Customers might get suspicious as to why another company is taking over payment collections. Being transparent about the factor’s role and that it is only temporary can help to alleviate suspicions.
Deciding to use invoice factoring or A/R isn’t the right question. Almost no business can run without A/R, which is how a business informs its clients that money is owed for merchandise or services rendered. It’s a core component of a business.
Invoice factoring is a complement to A/R and isn’t meant to replace A/R. Instead, it can speed up customer payments and increase cash flow. Most businesses won’t adopt invoice factoring permanently because the cost of doing so will become prohibitive. But using invoice factoring temporarily for adverse conditions or strategically to help kick off a project that is estimated to return more than is lost to invoice factoring are good reasons to use the service.
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