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What is Invoice Factoring: How it Works & Benefits

What is Invoice Factoring: How it Works & Benefits

Invoice factoring, especially for small businesses, has grown to become one of the chosen methods of acquiring much-needed finances. With a market size of nearly $1946.5 billion in the year 2021 alone, the industry is set to grow at a compounded annual rate of 9.4% over the next decade. So, what is invoice factoring? What makes it different from the existing financing options available to business owners?

In simple terms, factoring, while providing immediate access to cash flow, also allows you to shift the responsibility of collecting payment for your invoices to a third party. This enables you to manage your financial needs and focus efforts on your business. For businesses that invoice their clients, the waiting period can often be drawn out, complicating the fulfillment of immediate financial obligations. However, invoice factoring helps you address these conundrums.

What Is Invoice Factoring?

Invoice factoring is another type of financing when businesses sell their outstanding invoices to a factoring company in exchange for a majority portion of the dues. Factoring firms pay businesses between 80 and 90% of the amount due upon approval and release the remaining funds once the business’ client pays their invoice to the factoring company. This process involves the businesses handing over the responsibility of invoice collection to the factoring firm in exchange for immediate cash. Accounts receivable factoring is another term for invoice factoring - these are often used interchangeably. It allows businesses to manage finances and get access to funding quickly. The method is often faster than other options and provides a gateway for entrepreneurs to access quick cash.

To further simplify this, consider a simple example: Let’s suppose you own a roofing business and fulfill a contract for a construction project. Following the completion of work, you hand over an invoice of $25,000 to your client. Upon receiving the invoice, your client informs you that they will pay in 60 days. While this is agreed upon, you might also have immediate financial responsibilities such as restocking your inventory and procuring supplies for an upcoming contract. This situation presents a cash shortfall that can hamper your business’ forthcoming commitments. To address this, you approach a factoring firm that agrees to purchase your invoice in full and offers cash upfront upon approval. They deduct $1000 as factoring fees and offer you 85% of the remaining $24,000. You receive $20,400 in the next few days. Following disbursement, the company takes over the responsibility of collecting invoice payments from the construction project. Upon receipt, the factoring company pays you the remaining $3,600 and fulfills the agreement. This example illustrates invoice factoring’s meaning and how it works out for a business owner in need of immediate cash flow.

How Does Invoice Factoring Work?

As a business owner, apart from understanding the basics of invoice factoring, it’s also important to know how it works. Invoice factoring is a viable financing solution only for businesses that invoice their clients. This makes factoring more suited to businesses and service providers such as:

  • Independent contractors
  • Lawyers & legal firms
  • Architects
  • Designers
  • IT Consulting firms
  • Logistical contractors

Invoice factoring involves the following components:

  • Your business
  • Your customer
  • The factor (The company providing invoice factoring services)

To become eligible to apply for factoring finance, your firm needs to have provided tangible services to your clients. Following this, sending an invoice is also an integral step, as it becomes the core document for the factoring process. The following steps detail the process involved in invoice factoring:

  1. Your business offers a service to the customer, following which you send an invoice for your services to the customer.
  2. Your business receives an estimate of the number of days your customers require for the invoice payment.
  3. Your business collates the details of the invoice and applies them to factor invoices at the factoring firm.
  4. The factoring company analyzes the invoice and the payment history of your customer to assess the risk of purchasing the invoice from your business.
  5. The factoring company negotiates with your business on the amount it can offer on the invoice. Upon arriving at an understanding, the factoring company will disburse the amount to you after taking over the invoice from your business. The amount is often between 80 and 90% of the invoice.
  6. The customer eventually makes the invoice payment directly to the factoring company.
  7. Upon receipt, the factoring company releases the remaining amount to your business. The factoring company will also deduct a factoring fee or an interest rate depending on the time taken by your customer to pay the invoice.

The Benefits of Invoice Factoring

Invoice factoring offers several benefits over other financial services. These include

Swift Access to Cash - The process of approval and disbursement is faster when compared to conventional financing methods. This makes invoice factoring a great option for businesses looking to gain rapid access to much-needed finances. Businesses can apply for invoice factoring when they’re in urgent need of money to satisfy crucial business responsibilities.

Easy Approval - Factoring firms do not require ratings such as your credit score to approve and disburse amounts in the submitted invoices. Instead, they assess your client’s creditworthiness and payment histories before sanctioning the amount applied for. This allows even business owners with poor credit ratings to gain access to cash flow.

Avoid Loan Scams - Numerous business owners fall prey to dubious financing schemes and become victims of theft. Invoice factoring for businesses allows owners to avoid these potentially malicious financing schemes, and instead gain finances that rely on money owed to them by their clients.

Skip the Wait - Most clients take between 30 and 90 days to make their invoice payments. This can often throw a wrench in the plans of business owners looking to address immediate expenses such as paying staff or acquiring material. Invoice factoring allows them to avoid the waiting period entirely and gain access to instant cash through a factoring firm.

No Collateral Requirements - Numerous business financing options require entrepreneurs to pledge collateral. However, invoice factoring does not require collateral for your business to access finances.

Promotes Business Survival - Many small businesses survive on timely fulfillment and payment of invoices. Payment delays can threaten the financial stability of your business. In such situations, invoice factoring can help safeguard your business and help you sail through the waiting period.

Cheaper Financing Option - Despite having its associated charges and interest rates, invoice factoring provides a cheaper financial solution than conventional means available through banks and other institutions.

Smoother Collections - By selling your receivables to a third party, you hand over the responsibility of collecting the invoice payments to them. This allows you to remain free from the responsibility of repeatedly following up with your clients for payments.

Easy Cash Flow Forecasts - With money reaching your bank account within a short period, you can accurately predict and forecast your business’s cash flow and other financials. This is an important aspect of running a successful and steady business that can track its income with relative certainty.

What Is the Difference Between Invoice Factoring & Invoice Financing?

  • Invoice financing, though similar to invoice factoring, has considerable differences.
  • The core difference lies in the responsibility of collection. While the former ensures collection through the factoring firm, invoice financing leaves the responsibility of collecting payments with business owners. Repayments are made when the business owner receives invoice payments from their customers.
  • Invoice financing is similar to conventional financing in many ways. The method often features conventional interest rates and might even require collateral for financing larger amounts.
  • Invoice financing also demands good credit scores for approval. However, in invoice factoring, it’s the client’s credit history that is analyzed with greater scrutiny.

Now that you know what is invoice factoring and how it can aid small businesses, consider utilizing these versatile financial solutions to get access to quick and easy cash flow. Invoice factoring is available in both partial and complete variations, with the factoring firms fulfilling either all or a few of your payable invoices. Analyze your business requirements and pick the appropriate factoring company and option suited to your needs.

FAQs

What Are Accounts Receivable?

Accounts receivable includes all the money owed to your business by your clients. This is often common to businesses that fulfill their obligations before being paid. The payment rests on an agreement between both parties that the invoices will be paid entirely, soon after the rendering of services.

How Are Invoice Payments Collected After You Avail of an Invoice Factoring Service?

Invoice factoring firms take on the responsibility of collecting the payments from your clients that owe you money. Upon receipt of the payment, the factoring company releases the remainder of the amount due to your business.

What Are the Charges Involved in Invoice Factoring?

Invoice factoring involves factoring fees. This is often a rate that amounts to a fraction of the total amount in the invoice. Interest rates too might apply, depending on the firm and the amount disbursed.

Do I Require a Good Credit Score for Applying to an Invoice Factoring Service?

Invoice factoring firms only look at your clients’ credit ratings and payment histories. This allows even business owners with bad credit ratings to receive timely financing.what-is-invoice-factoring-for-businesses

Category: Business Spotlight