When most businesses need capital to finance expansion or a new product launch, they first turn to banks for help. But what if you just need to cover gaps in your cash flow and don’t want to commit to a long-term loan? That’s where alternative forms of financing, like invoice factoring come in.
How Does Invoice Factoring Work?
Also known as invoice financing, invoice factoring allows you to sell your invoices to a third party, known as a factor, at a discount.
Invoice factoring differs from a conventional loan in that you are selling your invoices rather than offering them as collateral. Consider it an advance on your invoices.
Once the invoice has been sold, the collection becomes the responsibility of the factoring company. The client or customer pays the factoring company within the deadline outlined by the terms of the invoice.
Once the invoice has been paid, you receive the remaining balance of the invoice, known as the reserve amount, minus the factoring company’s fees.
Invoice factoring allows businesses to obtain much-needed cash immediately instead of waiting 30, 60 or 90 days for clients to pay invoices. The funds can be used to cover gaps in cash flow and cover cash flow emergencies with minimal risk.
Who Uses Invoice Factoring?
Invoice factoring is used by entrepreneurs and businesses of all sizes, as it allows for flexible financing. Invoice funding can be used to generate financing and cover gaps in a business’ cash flow without having to make a big commitment.
About 50% of small business owners applied for financing in 2017, including invoice factoring. Invoice funding can be used by businesses of all sizes and in virtually every industry.
Types of Invoice Factoring
There are a few different classifications for invoice factoring as well as structures.
Invoice funding can be:
- Selective: Allows you to choose which invoices to finance and when
- Whole turnover: A business sells its invoices to a factoring company that advances at a percentage, typically 70-80%, and pays the rest (minus their service charge) when the invoice has been paid by the client.
- Spot factoring: Used for cash flow emergencies. Used infrequently, but provides quick cash.
Invoice funding can also be structured in three different ways:
- Factoring without recourse: With non-recourse invoice factoring, the liability of unpaid invoices falls on the factoring company. Business owners are not responsible for invoices that are not paid.
- Factoring with recourse: With recourse factoring, the business is responsible for unpaid invoices.
- Maturity factoring: With maturity factoring, the factoring company pays the invoiced amount (minus the financing fee) on the due date of the invoice.
Is Invoice Factoring a Good Idea?
Every business has its own unique needs. Invoice factoring may be a smart option for one business and not another.
Some businesses find the complexity and risks of taking out a bank loan to be more cost prohibitive than invoice factoring. Invoice funding is also a simple, straightforward way for businesses to obtain the capital they need. Many factoring companies are now offering more attractive fees than in the past, so costs aren’t as high as they once were.