When it comes to growing and operating your small business, cash flow challenges are prone to arise at some point.
Factoring is one way to alleviate these problems to get your business back on track.
One of the common culprits that many businesses face is invoicing and collecting accounts receivable payments. In these instances, invoice factoring can be a great solution.
But what are some of the advantages and disadvantages of factoring? Let’s find out!
Consider Invoice Factoring as a Cash Flow Solution
You likely 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 is more like taking a shortcut to receive funds that are due to you. Your company won’t add any liability (in the form of debt) to your balance sheet. Like any other financing mechanism, factoring has advantages and disadvantages.
How does Invoice Factoring Work?
Invoice factoring means your company sells the accounts receivable portfolio to a factoring company in exchange for a lump sum of cash, minus a fee (known as the factoring rate). In many cases, the advance payment can be up to 90 percent of your outstanding invoices. Then the factoring agent collects the money from your customer and pays you the balance minus their fee. Here is an illustration and timeline:
- You create an invoice for your customer in the amount of $10,000.
- The factoring company pays you up to $9,000.
- The factoring company collects the amount due from the customer.
- The factoring company deducts their fee (often two or three percent) and pays you $700 or $800.
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.
Advantages of Factoring
The most prominent advantage of factoring is gaining access to funds quickly. You’ll receive money fast 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 outstanding payments. Instead, you get paid right away by the factor, and their 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 type of financing compared to more traditional options. However, the fee you pay for the arrangement may depend in part on the credit quality and reputation 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.
Disadvantages of Factoring
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 avoid 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.
Impact of Factoring on the Customer Relationship
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.
The Bottom Line
Small businesses may encounter frequent challenges with collecting payment for current invoices due. Invoice factoring can offer a simple, low-cost solution to cash flow disruptions that can be vital to your businesses success.
There are a multitude of factoring companies available, but its important to find a reputable company with the lowest factoring rate.
Llama Loan can help you find the best match for your business so you can get the cash you need. Contact us today to find out more!