Businesses that sell products or services to commercial clients often find themselves in a financial bind. Many commercial clients require net-30 or net-60 payment terms in order to do business. Delivering their products or services is followed by a long waiting period for payment. During that waiting period, of course, business expenses aren’t put on hold. There are vendors to be paid, employees to be compensated, equipment to be purchased or repaired, and so on.
When cash flow gap problems occur as a result of this situation, it can leave a business struggling to keep up—and casting a shadow on its potential for future success. It can impact the ability to pay overhead bills, buy products on lower net invoicing terms and even pay staff on time.
Some businesses resort to applying for bank loans or a business line of credit—also a time-consuming process, with no guarantee of actually getting such bank-financed assistance. Many other businesses turn to a different solution offered by accounts receivable financing companies.
This process—also known as “invoice factoring”—involves the sale of accounts receivables in exchange for immediate (or near-immediate), partial payment on those invoices, as much as 70-80% of their gross value. (The remaining amount that isn’t immediately advanced is rebated, minus a service fee, after the clients have paid their invoices in full.)
How accounts receivable factoring works
Some business owners are still trying to wrap their heads around this increasingly popular funding alternative, because “an invoice is not a physical good, per se, and it’s hard to imagine how a factor could buy it.”
But, in fact, the process is fairly straightforward and can generate an effective solution to a company’s immediate cash-flow problems. With this influx of capital, a formerly cash-strapped business can pay vendors and employees, purchase equipment, etc., and benefit from enhanced liquidity.
The process works like this:
- Your business will submit a factoring application and all related materials in order to establish an agreement to sell accounts receivables to the factoring company.
- The factor undertakes a due diligence process, evaluating the quality of the invoices—more specifically, the overall creditworthiness of your customers. Depending on the situation, this review process can take a single day to a week. Upon approval, a formal agreement is signed between you and the factor.
- As soon as your customer accepts delivery of your products or services to the client, you submit the invoice to the finance company (or “factor”).
- The factor sends a Notice of Assignment (NOA) to the customers whose invoices are being financed, alerting them to the new invoice-collection process.
- The largest bulk of payment from the invoice takes place within one to two business days, with the balance of the outstanding debt (or rebate) paid upon the customer’s payment (minus the service charge).
One factoring mistake to avoid: Most factoring companies will not purchase a delinquent invoice or work with a customer known to have bad debt.
Key details in the invoice factoring process
Typically, a factoring company buys invoices online through a website or email, using a document known as a “schedule of accounts.” This consists of details of the accounts receivables you have sold to the factoring company. Upon receipt and processing of the document, you will receive funds via ACH direct deposit or by wire transfer.
Customer contact. A common concern among businesses employing invoice factoring for the first time is how their customers will respond to this new process. There are numerous reasons why a factoring company will work hard to maintain good relationships with your clients, including:
- The factor wants to secure payment of invoices.
- In the interests of ensuring a good relationship with you, the factor’s client, they don’t wish to do anything detrimental in their conduct with your customers.
- Factoring companies are obliged to follow the same collection laws as any other business.
Recourse and non-recourse. Two terms are generally present in any contract with a factoring company. They address situations where a customer neglects to pay an invoice when it comes due.
“Recourse transaction” describes a situation where the factor’s client (your business) must refund payment made by the factor if the customer doesn’t pay their invoice.
In a “non-recourse transaction,” the client is not obligated to return funds to a factor because of their customer’s insolvency.
Ongoing purchases of invoices. Assuming all goes well with the initial factoring process, you can continue selling invoices to the factor on a regular basis (or as the need arises).
This may be especially advantageous to:
- A business experiencing rapid growth, during which valuable administrative time is lost to submitting and collecting accounts receivables or:
- The business doesn’t have sufficient cash on hand to address debts incurred by that rapid growth (such as the need for greater supplies of the product and/or need to hire additional staff to meet growing customer demand).
“If you have individual customers or clients, you might want to collect personally,” notes business coach Jean Murray, “but if your customers are other businesses, you might decide that factoring can save you money and hassle.”
How to go about selecting a factor
If accounts receivables factoring sounds like a promising option for your business, how do you proceed to find the factor that works best for your needs?
You might start by consulting others in your professional network who have utilized invoice factoring in the past. If they’re happy with their factoring company, you’ll have a good recommendation as a starting point. Many factoring companies specialize in
Otherwise, many will search for factoring companies near me when conducting an online search for factors in your area (city or state). Choose a handful to interview, asking such questions as:
- What’s the extent of your experience with invoice factoring?
- Who in your company will make contact with my customers?
- How is that contact made?
- What professional standards do you have in place to assure my customers are treated with respect?
- Will I be notified if you decide to turn over an unpaid account to collections?
- What is your policy regarding regular communications with my business and me?
- Can you provide references from your other clients?
Invoice factoring isn’t necessarily the ideal solution for every business, but the number of companies opting for this form of invoice collection and payment is steadily growing. It’s certainly worth checking out!