Cash Flow Woes? Use Invoice Factoring.

Factoring companies pay you for your outstanding invoices

What Is Invoice Factoring?

Your business needs cash to operate. When cash is tied up as you wait for customers to pay you, it can create challenges in meeting payroll or paying your bills. Invoice factoring, also known as accounts receivable financing, may be an option to free up cash so you can cover expenses.

In invoice factoring, your business sells its outstanding invoices at a discount to a third party, called the factor. The factor pays you a portion of the invoice upfront, collects the money from your client, then repays you the remaining portion of the invoice — minus the factor’s fees.

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Amount

80% of the total invoice

Fees

1% to 5%

Time Frame

1 to 3 days

How Does Invoice Factoring Work?

Typically, the factoring company buys invoices in two installments. First, the invoices are bought at a discounted rate, generally about 80 percent of the total invoice. The remaining 20 percent, minus a factoring fee, is rebated when the invoiced client repays the invoice in full.

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What Are the Costs of Invoice Factoring?

Fees vary, depending on several issues, but factoring companies generally charge between 1 percent and 5 percent.

Here are some examples of what factors consider when determining their fees:

  • Invoice totals
  • Number of invoices sold
  • Industry
  • Client’s credit history
  • When invoices are due

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Example of Invoice and Fee Structure

Invoice

$50,000

First installment, paid right away

$40,000

Second installment after client payment

$10,000

Minus Fee (5%)

$2,500

Total received from invoice
$47,500

Questions to Ask Your Invoice Factoring Lender

Before signing on with a factoring company, compare invoice factoring offers from different business lenders. It’s a good idea to vet the factoring companies like you would do with an employee or subcontractor. The goal is to find a business partner who works with your clients, maintaining the good relationship you’ve built.

Here is your checklist of questions to ask your lender or factoring company.

  • What are the fees, costs and terms of the agreement?
  • Is there a minimum sales commitment?
  • What customer service and support do you provide?
  • How do you interact with clients when seeking payment?
  • How do you interact with clients who are late in paying?
  • Who assumes the risk of bad debt if an invoice remains unpaid?
  • Are there penalties for nonpayment?
  • Do you charge one-time fees or variable fees?
  • How soon will I get paid for each of the two installments?

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Is Invoice Factoring Right for My Business?

How do you decide if this is the right step for your business? Get all your questions answered. Do the math to see if it’s financially worth it. As with every business decision, balance the pros and cons carefully.

Compared to a traditional bank, working with a factoring company likely will be faster in terms of the application process and receiving your money. Factoring companies also tend to have a higher approval rate, so even startup and smaller businesses have a better chance of being approved.

Conversely, getting a line of credit from a bank would be less expensive than factoring. In addition, note that the factor may send a notice to the client, stating that payments should go to the factor. This may make your customers uncomfortable, especially if this method isn’t popular in your industry.

Before you proceed, you should compare your business finance options.

Invoice Financing

You use your accounts receivable as collateral for a loan, getting an advance for the total value. You repay the loan and a fee in installments. This is a good option if you have bad credit or if you need a small advance. Your business retains control of the ledgers, and works to receive payments from customers. This is also called invoice discounting.

Business Loans

Loans are usually received from a traditional lender. The business borrows money, and repays the balance and interest charges in regular payments. Sometimes, lenders will require collateral, which includes some asset (land, a building or inventory, for example) of similar value that is offered if the borrower fails to repay the loan.

Line of Credit

Banks traditionally offer lines of credit. The lender determines a maximum amount of money that can be accessed. Your business may borrow funds in various amounts, so long as it doesn’t exceed the maximum. The company makes regular payments on the loan.

Cash Advance

The most common type of cash advance is merchant cash advance, where a lender buys a set amount of projected future sales, which the borrower pays back over time. These loans are quick and easy to obtain. Advances often come with high annual percentage rates and fees, and short repayment schedules.

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Invoice Factoring and Taxes

invoice factoring taxes

The various factoring transactions and deductibles need to be recorded in the books. Your tax adviser should ensure you are reporting correctly to avoid getting flagged by the IRS.

What Are the Types of Invoice Factoring?

There are three basic types of invoice factoring.

Whole Ledger

All of your invoices are factored under a whole ledger or all-of-turnover agreement. This is more often considered for growing businesses or companies that want long-term solutions for invoice factoring. The cost per invoice is low compared to the other types. Factors often want a 12-month contract, which can limit flexibility and control in your business.

Partial Ledger

Another option for growing businesses and those that work with a variety of clients, partial ledger or selective factoring involves select invoices. This offers more flexibility in choosing which invoices to factor, such as capitalizing on clients who pay in full and on time, while omitting those invoices due quickly. The costs are typically slightly higher than with whole ledger, and often requires a contract of some duration.

Spot Factoring

Best for a quick, one-time influx of cash, spot factoring is the factor of a single invoice. Once it is repaid, the agreement is completed. Costs are often higher than partial or whole ledger factoring, as lending companies sometimes charge on a weekly basis. The advance rate is typically less than with ledger-type factors, about 65 percent for spot factoring compared to 80 percent for others.

Recourse vs. Nonrecourse

When considering invoice factoring and potential debt collection, the factor may offer the options of full recourse or nonrecourse. In full-recourse factoring, your business is liable if the client doesn’t pay, and must find another way to collect on the debt. In nonrecourse, your business is not liable for repayment only if the reason the client did not pay the invoice was because of insolvency. Factors often charge a higher fee for nonrecourse invoices.

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