One of the top challenges faced by most startups and small businesses is maintaining dependable cash flow. After all, cash is needed for everything from paying vendors (so you have products to sell to customers) to paying employees (who justifiably expect to be compensated for their efforts on behalf of your business). Without a reliable cash reserve, there’s a constant danger of falling behind in payments due – and never catching up again.
In the long run, a scenario like this ensures a rocky road ahead for any budding enterprise. This is simply a natural occurrence and one of the main reasons that there are benefits in using invoice factoring for small business.
The situation is further complicated by demands of clients for payment terms of 30-60 days in which to pay your invoices. Waiting for payment to be made while trying to grow the business is a nearly impossible process. The aforementioned vendors, employees and other related expenses aren’t going to wait a month or longer to get paid for their services.
So what’s the answer? While a viable funding source for some, venture capital just isn’t available to everyone. A bank loan or business line of credit often involves requirements many small businesses can’t meet. In the meantime, expenses keep building up and small business owners may fall farther and farther behind.
Invoice Factoring As A Small Business Solution
Increasingly, businesses across the U.S. are turning to invoice factoring as the solution to their cash-strapped predicament. Here’s how it works: A factoring company buys an asset (your accounts receivables, or invoices) and provides you with immediate cash payments.
Typically, the factoring company’s initial payment covers roughly 80-85% of the value of an invoice and gets wired to your bank very soon after you’ve delivered your products or services to the client. The remaining amount, 15-20%, is rebated, minus the factoring company’s fee, when the client pays the invoice in full. The actual rate for factoring invoices varies depending on risk of the invoice and the factoring companies that you work with.
However, with a near-immediate infusion of cash, entrepreneurs and business owners are far better placed to pay their own bills—thus keeping vendors and employees happy, and keeping business operations running smoothly.
When conducted properly (as noted below), invoice factoring (also known as “invoice finance”) “could be a suitable tool for easing cash flow and helping minimize risks associated with late payments.”
Is Factoring The Right Choice For Your Business?
Every small business has its own particular needs and challenges. Some industries rely heavily on the cash flow benefits which is why there are institutions such as freight bill factoring companies. If invoice factoring sounds like a plausible solution to your cash-flow situation, it’s worth considering the advantages and disadvantages before taking the next step. In the past Factoring Directory has covered many reasons why companies use factoring and How to avoid factoring mistakes, now we want to investigate when it is a good decision and what small business owners can expect when considering working with a factoring company.
First, let’s start with the benefits many businesses enjoy as a result of using invoice factoring to obtain urgently needed working capital without having to wait 30-60 days (or even longer, depending on late payments) for clients to pay their invoices.
- Businesses have an easier time qualifying for this type of funding than applying for a conventional bank loan or business line of credit. Basically, the requirements boil down to these key criteria:
- The customers you’re invoicing have solid commercial credit.
- You’ve successfully delivered your product or service to the client.
- Your business is free and clear of any tax or legal concerns.
- There are no existing liens or encumbrances on your accounts receivables.
- In contrast to conventional small business loans, an invoice factoring company doesn’t demand a mountain of paperwork be completed before your funding request is approved. Their focus is almost solely on the quality of your accounts receivable. That’s why this approach is “an attractive option if you have poor credit or have struggled to qualify for other small business loan types.”
- Funding comes through quickly. Once an account is established, invoices may be funded within a single business day.
- Equity participation in your business is not a condition for funding. This may be especially valuable for businesses in their early stages of operations, when true value has yet to be determined.
- Businesses can opt to factor all of their eligible invoices, or as many as they wish at any given time. Because of the flexibility of a factoring line, you can increase it as your business grows (say, if you sign a large purchasing order).
- The invoice factoring company serves as a “credit department” by verifying the commercial credit of your customers. It can offer guidance on the quality of a client’s invoice payment track record and steer you away from potentially unreliable clients.
At the same time, it’s important to recognize when invoice factoring is not the best solution. Here are considerations to keep in mind:
- The cost for financing your accounts receivables is often higher than other more traditional funding sources. (It’s best if and when your profit margins are sufficiently high.) Costs may range from 1.5% to 3.5% per 30 days.
- Invoice factoring addresses a very specific problem – cash-flow shortages caused by late- or slow-paying customers. Other difficulties, such as needing capital to repair or purchase technology, aren’t applicable here.
- Your customers will be made aware that payment is being sent to a third party. A Notice of Assignment is sent, apprising them of the factoring relationship. Sometimes clients may object to their form of invoice payment.
- Your customers must have good credit. Creditworthiness is the key requirement involved in this entire process. Without good commercial credit, such customers won’t be considered for invoice factoring. In such cases, “if they have bad credit, you should not be extending 30- to 60-day terms either.”
While invoice factoring may not be ideal choice for all startups and small businesses, the significant benefits of this funding option should be strongly considered before resorting to more conventional sources of cash.