Clients postponing payments according to invoices can cause a lot of trouble to your business and plans. Typically, slow-paying clients disrupt payrolls, bills, investments in machinery and technology, hiring new employees, or even taking new projects.
Luckily, the modern world has a simple and useful solution called invoice factoring. Typically, traditional bank loans have too high interest, plus it means that a company will be in debt. But what to do when low on cash flow and clients take 30 or more days to pay for a job performed a while ago?
That’s what invoice factoring offers. The business or independent contractor receives cash according to the invoice. Keep reading the article to learn more about invoice factoring and how it works.
Understanding Invoice Factoring
Invoice factoring (or debt factoring, invoice finance, asset-based lending) is a form of finance created for companies invoicing their customers and getting payment on specific terms. A factoring provider lends against the company’s customer invoices, allowing it to gain most of the invoice cash right away rather than waiting weeks or even months to get paid.
The amount of financial reimbursement available will typically be stated as a percentage of the company’s outstanding debtor book or sales ledger. It could be limited by certain terms, such as constraining exposure to a single large client.
Usually, payment company’s customers are supposed to go to the bank account controlled by a debt factoring company. The customer company will be aware that you are using factoring.
Some factoring providers guarantee an option to credit insure a specific customer or an entire sales ledger. That way, it’s possible to minimize the exposure to bad debts. These two options are called recourse and non-resource factoring.
Factoring is just one subcategory of invoice finance. Other types are:
- discounting, where a taxpayer remains in charge of their credit control;
- selective finance, where taxpayers choose which clients or invoices to finance.
The key factor to consider is risk. Factoring is considered lower risk since businesses gain more control over ensuring their clients pay on time.
For this reason, factoring is a go-to option for most companies with lower turnover, a shorter trading history, or any other challenging circumstances.
What is a Factoring Company?
A factoring company or provider (also a factor) is a financing partner. This partner purchases your unpaid invoices in exchange for cash. Once approved to work with the factoring partner, you can sell outstanding receivables to support the working capital and avoid the delay of long payment terms.
The factor verifies the company’s invoices gives up to 90% of funds according to the invoice face value. Then the factor gets paid due to invoices directly from the company’s customer (via a notice).
When the provider gets funds from the end client according to the standard payment terms, they give the remainder of the invoice value to the company. Naturally, these services come at a fee, so the remainder of the invoice value is lower due to fees. Typically, the fee is from one to five percent.
Keeping proper financial records is time-intensive and small mistakes can be costly. BooksTime makes sure your numbers are 100% accurate so you can focus on growing your business.
How does it Work
The factoring process is a rather simple and straightforward type of financing. If you understand how it works, it should be easy to decide if it’s the type of loan your company needs.
To understand the process better, let’s figure out who is involved in the transaction:
- a seller (a company with an unpaid invoice);
- the debtor (a company’s client);
- the factor (the lender);
These are the three main components of factoring. Now let’s check out the five key steps of the process:
- The seller provides services or delivers products, so they expect the debtor to pay according to an invoice. The seller sends an invoice to the debtor.
- The seller submits an invoice to the factor to get funds. For example, the seller submitted a request on day 5.
- The factor advances between 80% to 90% of the invoice value to the seller — the factor deposited funds into the business bank account of the seller on day 6.
- The debtor has to mail their payment to the factor, not to the seller. Money goes to the lockbox in the seller’s name on day 40.
- The remaining value (10-20%) of the invoice goes to the seller, minus a small fee of 1%. This happens on day 41.
As seen from the example, the process is simple and has low risk. The fee is small, and the company can easily support the cash flow and business operations.
Advantages and Disadvantages of Invoice Factoring
It’s true that there are many advantages to using factoring services. But companies should always consider possible drawbacks. Before choosing the type of loan, it’s critical to consider the nature of a small business and the factoring partner this business chooses to work with.
Here are some of the positive and negative sides of using the services of a factor.
- The business gets cash immediately.
- The business gets a faster approval of the process when compared to the traditional bank lending procedure.
- The company’s credit score isn’t affected.
If getting a traditional loan isn’t possible due to bad credit history, then it’s possible to get factor’s services. And this process won’t affect an already bad credit score. But let’s see the disadvantages.
- Hidden fees from factoring companies with a bad reputation.
- Lower profit margins for the business.
It’s crucial to choose a reliable factor to avoid trouble. More on how to choose a factor is described further in this article.
How to Choose a Factoring Company
As mentioned, it’s critical to choose the factor wisely. When seeking factors, companies often find thousands of options. Some are independent factors, and others belong to bigger banks. The best way to protect a business from factors with a bad reputation is to do thorough research. Check out what factors to pay attention to avoid trouble.
As you already know, there are two types of factors:
Here’s what to pay attention to in both cases:
- If a customer fails to pay the resource factor, then the business is supposed to give back the amount paid. Even though it does seem like a risk, the company gets better conditions — lower fees.
- According to non-recourse factoring, if a business’s client fails to pay to the factor, the provider reports a loss, not the business that gained money. It’s a lower risk, but such services typically have bigger fees to cover all their potential losses.
The best way to decide between resource and non-resource factor services is to consider the ability of a client to pay the debt. If the chances are high, then choose the resource factor with a lower fee. When in doubt, choose the non-resource type of factoring services.
Most small business owners should understand that factoring typically works among specific B2B businesses. Here are the industries that are successful with factoring:
- oil and gas;
- food and beverage;
- professional services;
- janitorial services;
- apparel enterprises;
- transportation and trucking.
It should be concerning if the factor offers loans in other industries.
When working with independent factors offering supposedly convenient fees, consider checking other fees hidden deep down in the agreement document. It’s critical to business owners to read the agreement thoroughly to avoid these “gifts.”
When in doubt, ask questions. It should help you to avoid losses in the future. Here is a list of potential hidden fees that aren’t normal and common:
- monthly minimum;
- cancellation or termination fees;
- float days;
- due diligence fees.
If you find any of these fees in your agreement, don’t sign it. Try to find a better factoring provider with transparent and honest fees.
Rates and Fee Structure
Clearly, factoring providers have specific rules on how to set rates and fees. Here are a few drivers used by factoring companies:
- The creditworthiness of debtors.
- The amount of the required loan.
- Invoice amount.
- The age of receivables.
- Whether the factor should finance all or only select invoices.
If the factoring company doesn’t disclose this data on their website, ask these questions to be sure you’re working with a reliable provider.
How to Qualify for Invoice Factoring?
The business should have specific items to be able to get a loan. Here is the list of these items:
- an invoice;
- a creditworthy client;
- a filled-out factoring application (blanks are offered by a factor on their website);
- a business bank account;
- an accounts receivable aging report;
- a tax ID;
- a valid form of personal identification.
As seen from the list, the client should be able to pay. In that case, it’s possible to apply for this type of loan.
Factored Receivables and Taxation
Undoubtedly, factoring offers multiple potential benefits for a business. But will this procedure affect the tax system in the US? Businesses find it difficult to identify whether factored receivables are subject to taxation according to the federal government.
The IRS sees several factors when they determine if the factored receivable qualifies as taxable. The IRS has guidelines describing what types of factored receivables should be taxable.
The agency also has the tools to prevent enterprises from using factoring to transfer income overseas or engage in tax avoidance. Before using factor’s services, consider checking the IRS guidelines on their website.
Is it a Good Idea to Use Factoring Services?
So, is it a good idea for a business to use factor’s services? Cash flow is critical to any company. It determines whether the company is going to flourish or face a bad ending.
When businesses are seeking factors, they often want to get loans from reliable sources within short periods. Reliable factoring providers often provide businesses with these quick solutions.
But how can someone tell if it’s a good idea to use factor’s services? Here’s a list of characteristics, if a business meets one or all of them, then it may be a good idea to use factoring:
- a business offers payment terms between 30 and 90 days;
- the business has B2B clients;
- the business has a limited operating history;
- the company has few or no assets to borrow.
Another factor to consider is credit history. If a company needs a loan, no financial institution will help if it has a bad credit score. If that’s the case, you may opt for factoring as the only viable and low-risk option.
Factoring is rather popular today, and the industry is competitive. That’s why there are many innovative solutions that factoring providers offer to their clients.
In some cases, it’s possible to get spot factoring when clients choose to finance just one client. Another option is selective factoring when clients finance just a single invoice. There are different possibilities, and you can choose the best for your business.
Author: Charles Lutwidge