So what is factoring? As a small business owner, you need capital in order to operate. You have employees to pay, vendors you owe, and numerous other expenses. Even if you have a steady flow of customers, it’s easy to see a cash shortfall, particularly if your customers don’t typically pay their bill for 30, 60 or 90 days after being invoiced. There is a way around this problem, though. Factoring can give you the cash you need now, without the challenges involved with obtaining a typical loan. So at the first place?
What Is Factoring?
Not sure what factoring actually is, or how it can benefit your business? It’s just a relatively straightforward situation, but there are a few things you’ll need to know. First, let’s define how the process works.
If your business is facing a cash shortfall, but you have customers with outstanding invoices, you can sell those invoices to a factoring company. In return, the factoring company will pay you (less a small fee).
You get the cash you need, and the factoring company then owns the invoice. You’ll have the cash you need to pay your employees, vendors or meet other business expenses, and the factoring company will have the invoice. That’s the end of the transaction.
Couldn’t you meet your financial obligations with a conventional loan from a bank? Yes, you could, but there are a few reasons that this might not be the best path to take. With a conventional loan, you generally have to work with a bank or other lender, and these institutions are notorious for dragging out the loan approval process. When you need cash immediately to meet a shortfall, the length of time you have to wait for approval can cause your financial problems to compound.
Of course, there’s also the fact that fewer and fewer banks are willing to make small business loans unless you have a sterling credit history and/or a significant amount of collateral to put up for the loan. Then there’s the fact that you’ll ultimately have to repay the loan plus interest, which means you end up owing more than you borrowed in the first place.
With factoring, you are not taking on any additional debt. In fact, you’re only taking on risk if there’s a possibility that your customer will not pay their invoice on time. You’re also not forced to go through the lengthy loan application and approval process, and there’s no need to worry about your own credit score. Your invoice is the collateral, and the money you’re paid is based on that amount, less the factor fee assessed by the factoring company.
How Does Factoring Work?
Now that we have covered what is factoring, while the process is pretty simple, it does involve more than just a simple sale of an invoice for cash. There are several steps that will be taken during the process.
- Step 1: You have an invoice for a customer that owes you money. This invoice is not due for at least 30 days, but you need the cash immediately to cover operating costs within your business.
- Step 2: You decide to sell the invoice to a factoring company to make up for the shortfall. You search for a reputable factoring business, and sell the invoice.
- Step 3: The factoring company pays you between 70 and 90% of the invoice value. They now own the invoice.
- Step 4: Your customer pays the invoice (the factoring company collects the invoice amount).
- Step 5: The factoring company pays you the remainder of the balance on the invoice sale, less the fees agreed upon in the beginning (generally between 1% and 5% of the total invoice amount).
The fee charged for business factoring will depend on several different factors. One of those is the amount of the invoice. Another is your customer’s creditworthiness. Obviously, the less creditworthy your customer, the more risk the factoring company takes on, so the higher the fee will be. It will also vary depending on whether this is a recourse or nonrecourse factor.
Another aspect that will affect your total cost for factoring is the length of the factoring period. Most factoring companies charge the discount rate weekly or monthly. So, if you sell an invoice with 90 days remaining, and the company charges fees monthly, it’s possible that you will pay that fee three times before your customer pays the invoice. This can add up quickly, so be very sure that you understand how the factoring company assesses fees.
Recourse vs. Nonrecourse Factors
To better understand what is factoring, you have to understand the difference between recourse and non-recourse. A recourse factor is simply a situation in which you are responsible if your customer does not pay the invoice. A nonrecourse factor is a situation in which the factoring company is responsible. If you’re responsible, and your customer doesn’t pay, you may be required to repay the amount the factoring company gave you, or you might have to replace the original (now defaulted) invoice with another one that has an equal value.
Obviously, if you have already spent the money the factoring company paid, and do not have another invoice of equal or greater value with which to replace the original one, this can create a very difficult situation, leaving you facing another cash shortfall. To avoid this potentially devastating situation, only factor invoices from customers who have proven their ability to pay invoices in a timely manner.
If the factoring company is responsible, then you have no obligations, but chances are good that the factoring fee (also called a discount rate) will be higher to offset the company’s higher risk. Check the contract you sign with the factoring company to determine what exemptions might be included that could still leave your business on the hook if your customer fails to pay the invoice on time.
There are also partial recourse contracts out there that have a mix of different features and requirements that center on who is responsible if the original customer does not pay the invoice on time (or at all).
Who Is a Good Fit for Business Factoring?
It’s important to understand that what is factoring and why it is not necessarily a good fit for all companies. In order to benefit here, you need an immediate requirement for cash (payroll costs, business operating costs, etc.), as well as a customer who owes money on an invoice that typically does not pay for at least 30 days. Of course, the terms of the invoice may vary, but they should not exceed 90 days.
In addition, your customer needs to be creditworthy, and should have a history of paying invoices on time, every time. This is not an area where you want to take on the additional risk of attempting to factor an invoice with a customer who is new, or who may sometimes struggle to pay on a timely basis.
The Pros and Cons of Business Factoring
As you might imagine, there are several pros and cons to factoring for business. Understanding these benefits and drawbacks is crucial prior to working with a factoring company.
- Get Cash Immediately: As mentioned, with a conventional loan, you must go through a lengthy approval process, and then wait even longer to get your money. With business factoring, you get your money immediately (up to 90%), and then the remaining balance when your customer pays the invoice. That means no waiting for the cash you need to keep your business running.
- Use It Whenever Necessary: One of the advantages of invoice factoring is the fact that you can use this solution whenever necessary to meet your cash shortfalls. All you need is an invoice due within the next 30, 60 or 90 days and a customer with a proven history of paying their invoices on time.
- Use It for Any Need: The money you get from factoring can be used for any need on the part of your business. There are no stipulations – it’s your money, after all. The factoring company is just giving you access to those funds sooner than if you were to wait for your customer to pay their bill.
- No Personal Credit Requirements: Unlike banks and other lenders, there is no need to consider your personal credit with factoring. This type of financial transaction is based on the creditworthiness of your customer, not yourself. If your customer has the ability to pay, and a history of paying on time, there should be no problem getting the cash you need.
- Cost: While invoice factoring can provide you with access to crucial cash during a shortfall, do not forget that this comes at a cost. You may be charged up to 5% of the invoice amount, and with lager bills, that can be a significant amount of money. There may also be additional fees and costs depending on what is factoring doing for your business. Make sure to read the fine print very closely and watch for not only hidden fees, but other costs involved with late payment on your customer’s part.
- Risk with Certain Customers: With invoice factoring, you give up control over part of your relationship with the customer. Because you’re technically selling the invoice to the factoring company, and that company will collect on the invoice, you want to ensure that they are reputable and have a history of fair dealing.
An unethical company could damage your relationship with the customer. This may also impact your business if you want to keep the factoring process discrete. Some companies do offer non-notification factoring, in which your customers are not notified of the sale of the invoice, or the factoring company’s involvement.
- Impact Due to Customers: As mentioned several times, if your customers do not have a proven track record of paying on a timely basis, you may not be able to take advantage of invoice factoring at all. The factoring company will definitely want to verify your customers’ creditworthiness prior to offering any money on the invoice.
As you can see, while the pros definitely outweigh the cons here, there are things that you’ll need to consider before working with any factoring company. You’ll also want to consider the length and type of contract the company wants you to sign – factoring companies sometimes want to lock their clients into long-term contracts that require very high fees to cancel, as well as minimums that might not work for your business. If you end up locked into a long-term contract but only need to factor invoices every now and then, you could be spending money for a service that you don’t actually need.
Invoice Factoring vs. Invoice Financing vs. Accounts Receivable Financing
There are many similar terms that are used interchangeably today, including invoice factoring, invoice financing and accounts receivable financing. While they’re all very similar, they are not always identical. For instance, understanding what is factoring type that you need for your business, the factoring company my end up handling collections on your invoices. With invoice financing, it is usually your responsibility to collect on the invoice. Accounts receivable financing, on the other hand, is essentially the same thing as invoice factoring.
Choosing the Right Factoring Company
As you have likely surmised from the information above, working with the right invoice factoring company is the most crucial consideration here. There are many different definition of what is factoring, and the types factoring companies out there, ranging from those that work within specific industries to generalists. There are also reputable companies, and those that should be avoided. We invite you to get a free consultation with one of our factoring specialists to learn more about what is factoring, and how it can help your cash flow. We have years of experience in helping our clients understand what is factoring, and navigate the sometimes murky waters of invoice factoring, and matching them with factoring companies that are right for their specific needs.