Invoice Factoring: The Ultimate Guide for Small Businesses

Eliminate invoice disputes

When it comes to dealing with your cash flow problem, you need expert advice to ensure availability of money for running your business. In most cases, small businesses wait around for accounts receivables to pay off monthly expenses. There are other ways to keep your cash flow intact without relying heavily on your clients to pay off the money they owe. This article will cover the ins and outs of invoice factoring.

What is invoice factoring?

While invoice factoring might be a foreign term to most, the process is simple. It involves selling invoices at a discount to companies known as factors in exchange for cash. With this method, businesses can operate normally without worrying about losses due to a client payment delays. Many businesses including transportation, staffing companies, media companies, government contractors and advertisers consider factoring beneficial because it ensures businesses run smoothly.

One of the reasons why businesses stop their operations is when they are dealing with cash flow problems because clients fail to pay in a timely manner.

How does it work?

Invoice factoring is no rocket science. Its process is straightforward as it starts off with selling outstanding invoices to factoring contract from companies. It is important to note that the business will not receive the full invoice amount. The factor reserves 5% to 30% of the value of invoice until the customer pays the full amount owed.

This way, the factor is also protected against the risk that factoring entails. The reserve will also cover refunds and chargebacks. So if you have an unpaid invoice with a value of $20,000 sold to a factoring company, you will receive 85% of the total cost upfront and the company will hold 15% as a reserve. Once your invoices are fully paid, the company will send you the 15% reserve, minus the fees.

Spot Factoring VS High Volume Factoring

Spot factoring’s main advantage is that you gain complete control over the invoices you choose to sell to factoring companies. A high-volume factoring, which is a traditional form of factoring requires businesses to enter into a contract to provide consent to factoring companies to sell most if not all of the invoices.

Spot factoring eliminates worries about additional charges and extra fees that are beyond the basic discount rate. Its discount rate is also much higher and riskier than high-volume factoring.

Recourse VS Non-Recourse Factoring

Recourse is a common type of factoring wherein you pay the bills that your customers are unable to pay. Since this arrangement is less riskier to the factor, the fees are usually smaller than other types of invoice factoring. However, you will still encounter problems in the future due to unpaid invoices if you do not have the resources to cover the costs.

Non-recourse factoring works differently because in the event your customer fails to pay, the factoring company will write off the debt. However, you should also keep in mind that there is still a need to re-purchase your unpaid invoices. This happens if the customer does not want to pay because the order has not been fulfilled correctly.

How Does Invoice Factoring Differ From Invoice Financing

While both invoice factoring and invoice financing are tools for maintaining cash flow, each of them has different roles to play.

  • Invoice factoring involves selling your invoices to a factor, which collects the invoices on your behalf.
  • Invoice financing is a type of loan that you take out using the invoice of your customers as collateral.

Terms and Conditions

A factoring company also prepares a contract which includes the following terms and conditions:

Length of contract and termination notice: The length of contract and termination notices vary from factor to factor. Some factoring companies require long-term contracts and early termination fees should you choose to cancel the contract before it is up. Other companies will only require you to give advanced termination notice.

The type of invoices factored: There are factoring companies that allow you to choose the invoices that you will sell. Some of them only choose invoices from specific customers while others will accept all your invoices.

Monthly minimum and maximum amount of invoices: Even the amount of invoices also vary each month. There are factoring companies that will limit the amount of invoices that businesses are allowed to sell.

Notification and non-notification factoring: If you want to keep your factoring arrangement confidential, you can set up a non-notification agreement with your factoring company. This means your customer will never know that you have sold their unpaid invoices. Notification factoring informs your customers of the arrangement.

Invoice Factoring Costs

Factoring companies charge discount rates and other fees for their services. When considering this financing option, here are the costs to expect:

Discount rate

The discount rate can range between 1% to 6% per month depending on the factoring company and the accrual of the rate. The longer it takes for your customers to pay, the larger the fees and rates will be. This is because fees are based on the levels of risk of each transaction. Invoice factoring will have higher fees if your customers are in a risky industry.

Additional Fees

There are also charge fees for maintenance, application, or other services that you may encounter:

  • Application fee: This fee may be charged upfront until your invoice has been paid.
  • Diligence fee: This is also referred to as a setup fee and should be paid upfront. You will incur this fee once the factor performs credit checks.
  • Maintenance fee: This is known as the administration or servicing fee. It covers all costs associated with your account.
  • Lockbox fee: This is a flat fee for keeping the lockbox open.
  • Wire Fee: This fee is applicable if you choose a wire transfer.
  • Early termination fee: The fee will be applied if you choose to cancel earlier than the agreed term.

Bottom Line

Be sure to find a factoring company you can trust by setting criteria. Take time to read the terms and conditions including the fine print to ensure you make informed decisions. Invoice factoring does not offer a one-size-fits-all solution so be sure to do the due diligence to obtain a wealth of information so you can make the most out of this financing option.

Interesting Related Article: “Ways to Eliminate Invoice Disputes for Faster Payments “