Invoice factoring can be an excellent short-term solution to get the funding needed to operate your business. It works by selling outstanding customer invoices to third-party companies in exchange for a lump sum of cash minus a small fee. Invoice factoring can be worth exploring if you have a reputable business with a solid foundation and need to obtain capital to move your business forward.
Let’s find out if invoice factoring is right for your business!
What is Invoice Factoring
Also known as accounts receivable factoring, invoice factoring is a fast and convenient way to collect a lump sum of cash in exchange for future customer payments for prior work.
Invoice factoring is eligible for companies that invoice customers for work, usually with NET 30 to NET 90 terms.
In many cases, you can advance up to 90% of your unpaid invoices for a quick cash injection into your business.
There are numerous considerations that factoring companies use to determine eligibility, including your business’s history, revenue, clientele, and more.
There are multiple types of factoring that will impact the costs of your financing, so you should analyze each to find the best fit for your business’s needs.
How Does Invoice Factoring Work?
While you may think invoice factoring works similarly to other loans, it’s quite different. Because you are selling the rights to outstanding invoices rather than obtaining capital based on your creditworthiness and collateral, qualifying for invoice factoring will require additional criteria than a traditional loan.
There are three main types of factoring invoicing – recourse, non-recourse, and partial-recourse factoring.
Recourse factoring is a more common type of factoring in which the factoring company is granted the rights to unpaid invoices. If customers pay after invoices are due, the factoring company can impose fees on your business that can be costly. For this reason, you should consider your customer base and their ability to pay when deciding to use recourse factoring.
Non-recourse factoring is less risky for business owners, but yields higher fees upfront from factoring companies. With this type of agreement, the factoring company is responsible for collecting invoice payments, and your business will not be held responsible if customers are unable to pay. Because of the additional risk assumed by the factoring company, this type of factoring is often the most costly, with the highest fees.
Partial-recourse factoring is a hybrid model that combines both methods in your factoring agreement.
Factoring agreements can be complex, so it’s essential to read and understand the details of your agreement to get a better idea of which party is responsible for unpaid invoices in certain circumstances.
To better demonstrate how invoice factoring works, we can use the example of a business looking to factor $100,000 in unpaid invoices.
Assuming your business agrees to a strict non-recourse factor – the factoring company may grant you up to $90,000 for your unpaid invoices minus a fee. You can expect to pay higher fees for non-recourse factoring because the factoring company will assume greater risk. In this scenario, we will assume a factoring fee of 5%, meaning your business could receive as much as $85,500 in cash upfront for your invoices. Once the invoices have been paid, you will also collect the remaining balance owed, which in this case is $9,500. In this scenario, the cost to factor your invoices would amount to $5,000 in factoring fees, plus any additional fees that are outlined in your agreement.
Fast and easy access to capital.
With invoice factoring, you can receive funds within ten business days in many cases. Because your credit is a tertiary factor in the approval process, it can be easier to get approved than with other funding methods.
More economical than traditional loan financing.
Invoice factoring can be lower cost than some traditional business loan offerings.
No collateral is required.
Because the invoices are being used as collateral, you won’t need tangible assets to be approved for invoice factoring.
It can be costly.
Depending on your business and outstanding invoices, sometimes invoice factoring can be more costly than a traditional small business loan.
Not available to every business.
Not every company will qualify for invoice factoring depending on the creditworthiness of your customers, your business history, and other factors.
Third-party access to customer data and communications.
Invoice factoring gives the factoring company direct access to communicate with your customers.
Invoice Factoring Requirements
The requirements for invoice factoring will vary from company to company, but standard requirements include the following:
- Customer profiles and credit history. Factory companies will want a detailed analysis of the companies invoiced and their creditworthiness.
- Customer payment history. Factory companies will require detailed payment history for the companies invoiced. Longtime customers with a proven track record of paying invoices on time and in full will increase your chances of being approved at a lower rate.
- Business history. You will be required to present profit and loss statements and other relevant business documents to aid in determining the risk level of your factoring. In some instances, you may be required to meet certain revenue minimums and be of a certain age to qualify.
- For most factoring companies, invoices must be payable within 90 days or less to qualify.
- Personal and business credit scores. While credit scores are used more for traditional loan options, they can also be used in invoice factoring to help determine your eligibility. While these aren’t heavily weighted in determining your eligibility, they can be a minor consideration.
Invoice Factoring Fees & Terms
Invoice factoring can be more complex than traditional business loans. Instead of a conventional interest rate on the balance of your loan, financiers will deduct an upfront fee from the balance of your unpaid invoices.
In addition to the factoring fee, companies may also include origination fees, incremental fees, non-recourse fees, ACH transaction fees, wire transfer fees, service fees, and other fees.
In most instances, the factoring fee will range between 1% to 5%, depending on the type of factoring and the level of risk the invoices hold.
Invoice Factoring vs. Invoice Financing: What’s the Difference?
Invoice factoring is slightly different from invoice financing in a few ways. With invoice financing, you will request a cash advance on your outstanding invoices, where you are still responsible for collecting payment.
With invoice factoring, you are selling the right to collect payment on your outstanding invoices to a third-party company at a discount.
The fees on invoice factoring can be higher, but it’s much less risky for business owners.
When Should your Business use Invoice Factoring?
Invoice factoring can be a suitable option for businesses facing an immediate cash crunch that need capital to operate their business.
This type of financing can be much more economical than traditional loans, business lines of credit, or financing options readily available.
The Bottom Line
Invoice factoring can be an easy way to obtain capital when you need it most. In many cases, you can receive funding for your outstanding invoices within ten business days – providing you with the cash you need to operate your business.
The fees and terms of your financing will depend on several factors, including the company you work with. To get the best rates, contact Llama Loan today for a comprehensive view of all of your options!