Invoice factoring: is it right for your business?

AAt some point in a business owner’s journey, it’s likely that they will need additional funding to help them operate or grow. Even if you have already qualified for a traditional business loan or worked with a generous investor to finance your initial start-up, there is no guarantee that these options will be available the next time you need money, especially in case of lack of time. This is where invoice factoring can come in handy.

What is invoice factoring?

Invoice factoring is a small business lending alternative that allows businesses to sell their invoices to a third-party factoring company, which then collects payments from customers. It is generally best for businesses that generate invoices to other businesses and need quick funding with flexible qualification requirements.

How does invoice factoring work?

When a business sells its invoices to a factoring company, it typically receives 70% to 95% of the total invoice value, known as the advance rate. Then the factoring company will collect the payment from the customers. Once the unpaid invoices are collected, the factoring company pays the company the remaining balance minus the factoring fee. Factor fees, whether fixed or variable, typically range from 0.50% to 5% per month that an invoice remains unpaid.

Example of invoice factoring

Let’s say you sell an invoice worth $25,000, receive an 80% advance rate, and pay a 5% postman fee. Here is an example of the total amount you would pay and receive.

Factoring with recourse or without recourse

There are two types of invoice factoring:

  • Recourse factoring. If a customer fails to pay their invoice, companies in a recourse factoring agreement are required to buy back that invoice from the factoring company at the end of the term.
  • Factoring without recourse. Third-party factoring companies take on more risk with non-recourse factoring because they can’t force you to buy an invoice if a customer doesn’t pay it back.

Because recourse factoring poses less risk to the factoring company, it is generally the most common arrangement. Additionally, non-recourse factoring fees are generally higher because they are riskier for factoring companies.

How to Choose an Invoice Factoring Company

There are many ways to compare an invoice factoring company. Factoring companies may charge different fees, have different minimum billing amounts, and work with different industries. Start by finding invoice factoring companies that work with your specific industry. Then, compare their fee schedules and qualification requirements to find a company that fits your specific business situation.

Advantages and disadvantages of invoice factoring

Benefits of Invoice Factoring

  • An easy way to improve your cash flow. Invoice factoring can be a faster and easier way to improve your cash flow without taking out a business loan or line of credit.
  • Might be easier to qualify for. If you have a damaged personal credit score, invoice factoring may be a better option — or your only option — than other types of business loans that have stricter qualification requirements.
  • Suitable for new businesses. If your business is new or doesn’t qualify for a traditional business loan, invoice factoring may be one of the few financing options available to you.

Disadvantages of Invoice Factoring

  • Potentially long contracts. Invoice factoring is not a one-time loan program. Some factoring companies may require you to sign a contract for up to one year.
  • May spend time chasing after bills. If you are only eligible for recourse factoring, you will be liable for all unpaid invoices. This can add more time and hassle than you want.

Invoice Factoring vs Invoice Financing

Factoring and invoice financing have one key difference that makes them two different types of business financing. When you choose invoice financing, instead of selling your invoices to a factoring company, your invoices serve as collateral — something of value that a lender can take back if you default — and secure a cash advance. Businesses that use invoice financing are responsible for collecting payments and using those funds to repay the lender.

Frequently Asked Questions

Is invoice factoring a good idea?

Whether or not invoice factoring is appropriate depends on your business, your cash flow, and other factors.

If you can qualify for a low-interest business loan, you could end up paying less than if you chose invoice factoring. But if your business is relatively new or has little or no cash flow, you may not qualify for a traditional business loan, or you will receive high interest rates if you do. In this case, invoice factoring may be an idea to consider.

How much does invoice factoring cost?

Factoring companies charge different fees, but most are between 0.5% and 5%. If you are interested in invoice factoring, you can contact a factoring company for a personalized quote. The exact fees you pay may depend on the volume of invoices, the industry of your business, and the creditworthiness of your customers, among other factors.

Is factoring an invoice a loan?

Factoring is not a traditional business loan where you receive a lump sum of money and pay it back over time. Instead, you will receive part of the invoice amount in advance from a factoring company. Once the factoring company collects the invoices, you will receive the balance minus any fees.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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