For any small business, cash flow can be a challenge. If your company is doing well, you have solid sales and favorable profit margins. But you may have trouble keeping up with payroll or paying your suppliers on time. In that scenario, you may have a cash flow problem to address. Cash flow obstacles typically occur when your customers take too long to pay your invoices. If you are part of an industry that traditionally allows 30, 60, or even 90 days for invoice payment, that delay may create difficulties for your sustained profitability and growth.
You may have several options for resolving your cash flow concern. First, you could apply for a loan or line of credit to have on standby when you need more cash than what is available. With a loan, you will make fixed payments whether you use the money or not. In contrast, if you obtain a business line of credit, you only make payments if you use the available funds, and the amount you pay will vary depending on how much of the line you use. In addition, a line of credit is reusable: if you use a portion and then pay it back, you can use it again without applying for a new loan.
Invoice factoring means your company sells the accounts receivable portfolio to a factoring company. That company pays you upfront for most of the value of the invoices. In many cases, the advance payment is 90 percent. Then the factoring agent collects the money from your customer and pays you the balance minus their fee. Here is an illustration and timeline:
Depending on how long the customer waits to pay the invoice, you may have had the bulk of what they owed you for quite some time.
Certainly, the most prominent advantage of factoring is gaining access to funds when needed. You get money quickly but at a slight discount by selling the accounts receivable portfolio to a factoring company. The factor earns its fee by doing the follow-up necessary to collect the amount owed.
Another benefit is that you don’t have to spend time and energy chasing down the payments. Instead, you get paid right away by the factor, and their professional staff manages the interaction with the customer.
Since factoring doesn’t depend on your business’ credit quality, it may be easier for you to qualify for this transaction than get a loan. However, the fee you pay for the arrangement may depend in part on the credit quality of your customers.
It’s definitely an advantage to have quick access to payments that are due and to avoid accumulating debt and interest payments. Further, the factoring arrangement doesn’t typically have long-term obligations or consequences.
Clearly, getting 100 percent of the money owed to you is better than getting 95-98 percent. But there is a price for convenience. Keep in mind that you are selling the accounts receivable portfolio in return for fast, dependable payments and the freedom to not work on bill collection.
That freedom does depend on whether you are engaging in recourse or non-recourse factoring. With recourse factoring, the factoring company can return the outstanding invoices to you for a refund if they can’t collect the payment within an agreed-on period. Then it’s your job to collect, and you must repay the advance you received. If you sell the invoices on a non-recourse basis, the factoring company is stuck with any balance they can’t collect. With a non-recourse arrangement, the fee will be higher, and the customer’s credit status and payment history are vital. Keep in mind that factoring refers to the sale of current invoices. It isn’t debt collection for customers who can’t or won’t pay.
Another potential disadvantage of factoring is involved when the factoring agent requires an entire portfolio sale for a lengthy period. You might prefer to sell just some of the invoices, which is called spot ledger financing. However, the factor may prefer to take the entire ledger. They may also require that you continue the practice for a set time, such as a year. Usually, these terms are negotiable, but choosing the more favorable options for your business will likely increase the percentage fee you pay for convenience.
Depending on the customer, this variable might fall under the advantages or disadvantages of factoring. For example, if the customer thinks that your company is unstable due to the sale of the receivables or that you don’t trust them to pay promptly, that could harm the relationship, which would be a disadvantage.
On the other hand, removing the collection of payment from your interactions with the customer could transform the relationship into a more positive one focused on how you can help the customer thrive using your products or services.
Small businesses may encounter frequent or just occasional challenges with collecting payment for current invoices due. Invoice factoring can offer a simple, low-cost solution to cash flow disruptions. Carefully consider the costs and benefits before you enter into a contract for this service.