The “Rights” and the “Wrongs” of Using Invoice Factoring
Waiting for an invoice to get paid is one of the most frustrating and stressful aspects of being a small business owner — it’s even worse when a client doesn’t pay the invoice on-time. Well, no, it’s worse when a friend doesn’t pay their invoice on time. But, you see what I mean.
Did you know that there’s a way to make some quick cash off of those unpaid invoices?
It’s called invoice factoring. If your curiosity is piqued, I’ve put together a brief overview of invoice factoring. More importantly you’ll know the “rights” and “wrongs” of using invoice factoring.
An Overview of Invoice Factoring
What is invoice factoring and how does it work?
Invoice factoring is simply where you sell unpaid invoices at a discount. The factoring company gives you cash to secure working capital to meet your expenses. You can cover payroll, or expand sales, or whatever.
The factoring company then takes over the invoice and gets paid whenever they collect the debt from your customers. This usually takes anywhere from 30 to 90 days. It depends on the terms that you and your clients have agreed-on.
In most cases, you’ll receive 80 percent of the invoice amount now and 20 percent (minus fees) when the invoice is paid-in-full. But, this can vary from factoring company to factoring company.
For example, you sent out an invoice for $5,000, and you can’t wait 30 days for the client to pay it in full. Let’s say you need payroll now so you turn to an invoice factoring company.
They’ll purchase the invoice and give you $4,000 upfront, which is 80% of the invoice. They send you the remaining 20% after the invoice has been paid.
Keep in mind, however, that since they’re charging you a 3% factoring fee, they’re going to keep a $150 for themselves. But, hey, you have to do what you have to do.
Invoice factoring pros and cons.
- Immediate working capital to help cover any funding caps that have been caused by clients who don’t pay on-time.
- Improved cash flow for your business.
- Invoice factoring often provides an easier to obtain capital. You don’t have to worry about your credit score, collateral, or limited operating history.
- Invoice factoring can get expensive due to hidden fees. These fees include application fees, processing fees for each invoice you finance and credit check fees. Many charge late fees if the client stays past due on a payment.
- Since the invoice factoring company is collecting the invoices directly, you don’t have control over your billing anymore. Make sure that the factoring company is being ethical and fair when dealing with your customers.
- Factoring companies verify the creditworthiness of your clients. This means if they have bad credit, you may not be approved.
The Right Way to Use Invoice Factoring
Unlike cash advances, loans, lines of credit, the funds acquired through factoring are pretty identical to your regular income.
This means that it should be used just like the way you would use the cash that’s flowing into your business. You’ll want to pay employees, repair equipment, or replenish the supplies.
If you have some extra money left over, you could put it towards expanding your business by introducing new products or services. But use the factoring money for actual expenses, not taking 200 to lunch or an impromptu event.
Launching a new marketing campaign, or relocating to a larger workspace may be considered, if it was already in the works. Some businesses have gotten in real financial trouble thinking of factoring monies as a bonus.
Josh Smith from Alpha Capital explains this perfectly in a LinkedIn post, “Invoice factoring is meant to grow your company. Plainly put, that means investing your cash infusion into the chain of production so that you can expand your revenues and profits.”
For example, a manufacturer would use the money from invoice factoring to increase “the quantity and/or quality of raw materials and assemblies used to create finished products.” A merchandisers could “spend the cash on additional product orders and perhaps expanding the types and quality of the products you sell.”
The Wrong Way to Use Invoice Factoring
The wrong way to use factoring is to use it for financing your company. Smith has an example of a widget maker who diverted the $200,000 he acquired from factoring towards a fleet of trucks, as opposed to the materials required to increase widget production. “Now he has a shiny new truck fleet but no increase in output.”
While funds from factoring are easier to obtain, they tend to be more expensive than traditional bank loans. For example, the APR from a SBA loan is 10%, while the APR from a factoring company can range anywhere from 17% to 64%.
In short, factoring is a better option for strong businesses that need a short-term cash injection to cover their essential business needs. If your business is weak, factoring can actually prevent your business from growing because of how much it costs you to work with a factoring company in the first place, or because you used the funds incorrectly.
Invoice Factoring Mistakes to Avoid
If you believe that you can use factoring the “right” way, then make sure that take into consideration the following:
- Ask, “How much upfront?” A fair advance is 70-90% of the face value of the invoice.
- Look for transparent rates and fees. BlueVine has put together this handy guide for deciphering invoice factoring rates and tricks.
- Don’t sign long-term contracts. You’re probably only going to need factoring occasionally, so you don’t want to get trapped in paying something that you never use.
- Direct payments to the factoring company. Once you hand over an invoice, the payment must be made to the factoring company. Inform your clients so that they aren’t sending you the payment. If you’re concerned about your customer’s confidentiality, use factoring companies that uses “non-notification factoring.”
- Submitting a purchase order. You can not submit purchase orders since they only represent services or products have yet to be delivered.
- Forgetting about paperwork. While funds are available quickly, factoring still involves some time-consuming paperwork.
- Financing vs. Factoring. You may be better off using an invoice financing company where invoices are used as collateral.
- Shop and compare. Factoring Explorer easily allows you to shop and compare 140 factoring companies by industry and location. You can also use the site to get a quote.