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Updated: December 1st, 2020
Did you know that more than 80% of small businesses never make it due cash flow mismanagement? It’s easy to see how any short-term hiccups in cash-flow can affect the entire business, from payroll to suppliers. All it takes is one large order for things to become untenable.
On one hand, filling a large order can catapult your business to the next level. On the other hand, it can require a major investment in inventory that, if not handled correctly, can disrupt your ability to pay other important expenses. Worse, it could be 60 days or longer before your new customer pays you. This could feel like an eternity when you are dependent on day-to-day cash flow for your business’ survival. Fortunately, when opportunity comes knocking, you don’t have to close the door in its face.
One tried and true method of financing is called invoice factoring, and it can help to fill any gaps in cash flow. Let’s explore how invoice factoring works for big and small businesses below.
Invoice factoring has stood the test of time and dates back thousands of years to Mesopotamian merchants. Since then, clay tokens have been replaced by contracts and invoices while barley has been replaced by cash as the method of payment.
The concept, however, remains similar: convert your accounts receivable at a discount into cash with invoice factoring. So rather than sitting and collecting dust, the invoices can be turned into cash relatively quickly. The invoice factoring company takes possession of the invoices and typically collects payment on behalf of the business within a given time period. This could be anywhere from 30 to 90 days. In a few short steps, this is how it works for businesses-
Considering that you have already secured the business, you’re not really bolstering your debt. Instead, you’re getting access to cash quickly to address short-term capital needs. You don’t have to wait months for payment. You can expect to receive the cash in two separate payments — including an advance for between 80-85% of the invoice. This is followed by the balance minus fees after the customer has paid the invoice in full. In exchange for this convenience, there are layers of fees involved. As a result, you may want to compare rates across invoice factoring companies before you sign on the dotted line. Factoring fees can range from 0.5% to 4% per month.
The best way to understand how invoice factoring works is to see it in action. Let’s say you have $20,000 in accounts receivable. You apply for invoice factoring with an invoice factoring company and are approved. So for $20,000 at a 2% fee, you can expect the following fee scale:
The invoice factoring company might instead go by a flat fee, which is not tied to the length of time the customer takes to repay the invoice. If the flat fee is 5%, you pay $1,000 on the $20,000 factoring regardless of how long it takes your customer to pay the invoice.
It is also very possible that there will be other fees involved, which will vary based on the invoice factoring company. These could include a setup fee, which is similar to a loan origination fee, a lockbox fee to cover the account in which the customer will send the payments, a potential wire fee, and any late fees if applicable.
When you choose to go the invoice factoring route, be prepared for the company providing the financing to contact your customers. Or they might ask you to let your customers know. It’s possible that involving another company with the invoicing process could rub your customers the wrong way. On the flip side, if your customer is late to pay the invoice, it will increase the cost of the financing for you.
While invoice factoring is a form of financing, it’s not a loan. If you are trying to decide between a term loan and invoice factoring, it may come down to your specific needs and the conditions of your business. When time is of the essence, these two forms of financing are competitive. Invoice factoring can have the first installment in your account within 24 hours, while a business loan can take as few as three days with Funding Circle.
One of the main reasons that a business owner might choose invoice factoring over a business loan is a lack of credit history or their credit score needs work. To be approved for a term loan, the lender will consider both your personal and business credit scores in the decision-making process.
On the other hand, the invoice factoring company will most likely be most concerned with the credit of the invoiced customer, considering they will be the ones paying the invoice. If you use the cash from invoice factoring to pay suppliers, you are building a good relationship by making timely payments. This could benefit your business credit score for the next time you need financing, especially if you want to pursue a term loan.
Only you know what’s best for your business. And now you know how invoice factoring for small businesses may or may not fit into that scenario.