As cash begins running low and customer payments aren’t expected for days or weeks, impacted business owners can feel as though the walls are closing in. Cash flow greases daily operations and keeps everything in the business going. Cash flow can dry up because customers wait until the last second before paying their invoices. This delay creates a gap, or what some might call a dead zone, between when an invoice is issued and when payment is received.
It’s up to the business to fund this gap. A business that isn’t able to fund the gap needs to borrow money or sale-down inventory. When that doesn’t work, the business has another lever it can pull. It’s called invoice factoring.
What Is Invoice Factoring?
Invoice factoring means selling your invoices for a percentage of their value. A company, known as a “factor,” takes over payment collections for outstanding invoices. The factor will immediately advance 80 percent or more to the business. The remaining 20 percent (called the reserve) minus the factor’s fee is advanced upon payment collection. Factor fees are often around 3.5% of the outstanding invoice value.
The immediate injection of cash can be exactly what a cash-starved company needs to stay afloat. However, continually using invoice factoring means something more systemic is going on in the company. Invoice net terms or inventories might need to be adjusted to ensure cash flow is continuous and the company has enough money to operate.
When it’s time for a cash advance from the factor, the business sends a request to the factor. How the request is sent and how much is involved depends on the factor.
There are a few qualifications required before a business can use invoice factoring.
Invoice must be commercial. Consumer-based businesses won’t be able to use invoice factoring.
B2B or B2G -
The business must work with business-to-business or business-to-government customers.
Creditworthy Customers -
The business’ customers must be creditworthy, as determined by the factor.
Monthly Volume -
The business must generate a certain amount of revenue in invoices per month.
Despite the above requirements, it is easier to qualify for invoice factoring than for a traditional bank loan. Also, the business doesn’t have to take on any new debt.
Are There Any Disadvantages?
One major disadvantage of invoice factoring is the loss of control. The business must give up payments’ collections to another company. Customers will no longer send payments to you but, instead, send them to the factor. How well the factor handles payment collections (think customer service) can impact your business. Using a factor can also send a negative message to customers that something is wrong with your business.
To avoid confusion, it’s best to let customers know a change is coming well ahead of time. Tell them what a factor is, the role they’ll play, and why a factor is being used. The explanation might be as simple as you decided to choose a factor over the laborious process of getting a traditional loan.
Customers are notified by the factor of the payment collections change through a Notice of Assignment.
When Should A Business Use Invoice Factoring?
Businesses that do not yet have their accounts receivable cycle under control and find that they are running out of cash while waiting for customer payments are good candidates for invoice factoring.
Taking advantage of an unexpected opportunity is another reason to use invoice factoring. In this case, the business’ cash flows are fine, but cash on hand and other financing options aren’t enough to take advantage of an opportunity. If the cost of invoice factoring is less than the return on the opportunity, then invoice factoring is a great option for financing.
Similar to the above paragraph, invoice factoring can help businesses to grow. New projects and hiring of talent are all costly endeavors but can be necessary to take a business to the next level.
Outsourced Payment Collections
Collecting payment on invoices can be time-consuming. Many companies have a department dedicated to this task. When a factor is hired, the responsibility of dealing with payment collections falls on it and off of you.
Invoice factoring is flexible and can suit a number of needs that a business may have. From teetering on the brink of disaster to needing additional funds for a project, invoice factoring provides a needed and immediate cash infusion. Businesses should communicate to their customers the role of the factor. Early communication can help ensure that customers are comfortable with the new change, allowing business operations to continue as usual without interruptions.