One of the perennial headaches for small businesses is the collection of accounts receivable. Whenever you sell something to a customer, you provide them with an invoice stating the product or service rendered, the price, and the terms – or when the money is due. Then, you wait for payment.
In most cases, your customer expects you to allow 30 or 60 days for them to pay. That can seem like an eternity when you are trying to buy materials or make payroll. Of course, you can try to collect the invoice sooner by nagging, but you risk your customer developing concerns about your financial viability. In reality, invoice payments often lag even the 60-day timeline. Recently Wave, a business payment processor, reported results from a survey indicating that 70 percent of microbusiness owners routinely wait between one and six months for invoice payments.
Managing cash flow is often a major obstacle for small businesses, and that’s where a factoring company can come into play.
A factoring company is a business that operates by liquidating a set of unpaid invoices in exchange for a fee, known as the factoring rate.
In short, these companies can help small businesses get access to capital in exchange for a select group of outstanding invoices.
There are some tools and processes you can use to encourage prompt invoice payments from customers. Some popular methods include:
Still, some customers will drag the process out longer than is comfortable. They may have their own cash flow constraints, creating a domino effect, or they may just prefer to hold onto their cash as long as possible. Either way, you have to find the balance between collecting what they owe you and keeping them as customers.
Invoice factoring is another term for accounts receivable financing. It involves selling your outstanding (unpaid) invoices to a factoring company for cash. Typically, the factoring company will pay up to 90 percent of the invoice value, collect the funds due, and then pay the balance minus their fee for the service.
For example, suppose that XYZ company owes your small business $10,000 for products they purchased and you delivered. If you sell the open invoice to a factoring company, you might receive $9,000 immediately. After the factoring company successfully collects the balance due, they will remit an additional five to nine percent to you, keeping the remainder in return for their service and the advanced payment.
The fees charged by the factoring company will be predetermined when you inquire about this form of financing. Some companies are more competitive than others, so it’s wise to shop around for the best rates or contact a broker like Llama Loan to gather all of your options.
No, there is a significant difference between these two methods of obtaining cash.
In invoice financing, you could use the outstanding invoices as collateral for a loan, but you still have the responsibility to collect on the invoice. So, depending on the loan terms you have available, you might save money by invoice financing, but it doesn’t relieve you of the burden of getting your customers to pay.
With invoice factoring, you can choose to finance a portion (or the entire amount) of your unpaid invoices in exchange for a lump sum of cash, minus the factoring fee. Whenever customers make a payment, the money is paid directly to the factoring company instead of your business.
If you have some customers that pay immediately and some that are habitually tardy, you might not want to surrender two to five percent of the invoice value for factoring services for the entire customer base. Some factors allow spot factoring, meaning you can choose which invoice(s) to sell. Others require whole ledger factoring, meaning that you sell all your invoices.
If you have clients with different payment habits, opting for a spot factor arrangement makes sense. However, keep in mind that doing so will cost more since you are only financing your recalcitrant payors. For example, you might be able to negotiate a two percent fee rate for a whole ledger factor transaction but pay six percent for financing just one.
Invoice factoring is not debt collection. Instead, your business is financing your current invoices as you issue them, not trying to collect on past-due obligations. However, the factoring company sometimes has trouble getting the customer to pay. There are two ways to approach this potential. Recourse factoring is the standard method of financing your accounts receivables. In that scenario, your company will buy back any invoice for which the factoring company can’t collect payment. You can then try to collect the amount due or use a collection agency. If you have a non-recourse agreement, the factoring company is stuck with the unpaid debt. Because of the additional risk to the factoring company, you will pay a higher fee for non-recourse factoring.
If your small business has primarily B2B customers, invoice factoring might be the right answer for your cash flow concerns. However, remember that your business credit isn’t relevant to the approval or the fees you can negotiate. What matters is the creditworthiness and reputation of your customers. If you have some customers with frequent late payments, you may not get as favorable rates from some factoring companies.
Invoice factoring fees can take a chunk out of your profits, but it may be worth the price in some cases. Before committing to any financing, be sure to browse lenders like Llama Loan so you can get access to the best rates and terms available.