What Is Invoice Factoring for Small Business?

When you launch a new business, there is paperwork, probable debt, legal issues, and so much more to keep track of. You must also learn to balance your personal life alongside it all.

Getting your finances in shape is a top priority for your startup to succeed. If someone should mention using invoice factoring as a solution for a cash flow problem, you might not recognize the phrase, especially if you’re new to entrepreneurial efforts.

If you own a small business, here’s a guide to help you decide whether invoice factoring might be suitable for you.

What Exactly is Invoice Factoring?

If your firm does invoicing of any kind, invoice factoring could be a huge benefit. In essence, invoice factoring is like obtaining a short-term loan that supplies capital in exchange for a fee to a factoring company, which is also known as a factor.

But unlike a loan, you don’t have to pay it back. You’ll sell invoices to a factoring company at a discount and receive a lump sum for them. The factor will provide a percentage (usually about 80 percent) of the total value of your invoices.

At this point, the invoice is no longer your property. The factoring company will collect from your customers when they are ready to pay. After the invoice has been paid, the factor will pass along the remaining 20 percent to you, minus its fees.

Here’s an example. Let’s say you sell fresh produce to a chain restaurant. You’ve generated your invoice for $5, 000, and the customer has agreed to pay it within 30 days of issuance. But you’re a little short on cash and need the money to pay your employees by next week.

What Is Invoice Factoring for Small Business? Image by StockSnap from Pixabay
What Is Invoice Factoring for Small Business? Image by StockSnap from Pixabay

Rather than miss a paycheck, take out another loan, or sell something to meet your responsibilities, you can opt for invoice factoring to make up the difference. The factoring company agrees to purchase your $5,000 invoice for $4,750, which means it will make $250 through its 5 percent factoring fee.

The company gives your firm a lump sum of 80 percent of the invoice value now. Later, when the customer pays, the factor gives you the other 20 percent (minus its fees). This is a useful way to handle invoices that have a due date in the middle future when you need the money a bit sooner.

It’s essential that you don’t confuse invoice factoring with invoice financing or accounts receivable financing. The terms are too often employed interchangeably in error.

Factoring requires that invoices be assigned, as distinguished from the streamlined methods for presenting money to a client or a business through invoice financing or accounts receivable financing.

Is Invoice Factoring Right for Me?

For companies that are short on cash or have to deal with delinquent clients, factoring might be a viable option. Other firms might expend too much on the factoring fee, which may range between one and five percent, depending on the company and your situation.

It’s wise to research the best invoice factoring companies thoroughly and identify the advantages and disadvantages involved.

Pro: Better Overall Cash Flow

If your business operates from paycheck to paycheck, as many do, invoice factoring offers the freedom of smoother cash flow. You’ll have the money you need to pay your bills, which may be worth it even if you have to pay a fee to get it.

Con: Fees and Expenses

Depending on who offers the service and the fee, you can lose a chunk of each invoice to the factoring company because of the percentage it demands for the service. You might also encounter hidden fees such as credit check, processing, application, or late payment assessments if your client pays late. Also, your fees might go up if you have too many clients who pay late.

Pro: Easier Access to Money

This method entails no loan qualifications, no collateral, and no credit checks to see whether you qualify. Companies that are tired of being told no by traditional lenders can fix their cash flow problem and focus on expanding their business.

Con: Financial Risk

There’s an inherent risk to handing your invoices over to another party. Although factoring companies aren’t notoriously picky about offering funding, there may not be a guarantee that you can keep the money they give you.

If your customer never pays or it is really late on payments, the factoring company might require you to buy back the invoice and handle the delinquent notice yourself.

As with every software you purchase, you’ll have to weigh the pros and cons to decide what’s a worthwhile investment. Invoicing software can be a great tool for making ends meet while your business grows, but you mustn’t plan to rely on it forever.

Getting your outfit into tip-top financial shape should be the ultimate goal. But in the meantime, invoice factoring is an option to help you fill in the gaps.

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Melissa Thompson

Melissa is a mother of 2, lives in Utah, and writes for a multitude of sites. She is currently the EIC of HarcourtHealth.com and writes about health, wellness, and business topics.