Factoring is a financing tool to turn unpaid invoices into cash
Invoice factoring basics
- Collect cash advance in exchange for outstanding customer invoices.
- Typically used for short-term business needs.
- Cheaper than some loans, but still a relatively expensive financing tool.
- In addition to paying upfront fees, businesses are responsible if customers don't pay up.
If you own a small business and want to list your assets, you might think of buildings, inventory and equipment. But healthy companies have another resource that's less tangible, although no less valuable: their accounts receivable, or the money owed them by customers who've already purchased goods and services.
That owed-money is valuable enough that it can be the source of some short-term financing, in the form of invoice factoring. Small businesses sell their invoices — the record of the amount customers are obligated to pay over a set period of months — to companies known as factors. Factors advance the small business money on the assumption that the factor will collect from the customers.
Although it sounds like a loan, it's not. Invoice factoring actually involves the sale of payments owed to the factoring company. When all goes well, the invoice factoring works something like a business line of credit. You get immediate cash that you can use as you decide, usually to cover short-term cash-flow shortfalls that might be caused by higher than usual expenses or a predictable slowdown in business.
If you're thinking of tapping an invoice factor, your chances of being approved will be better if you operate a business-to-business company. The factoring companies are much less likely to advance money based on debt owed by individuals.
When you enter into the deal, you sell your invoices due in 30 to 90 days to the factoring company, which charges a factoring fee of 1 percent to 5 percent of the total value of the invoices. Then, the factor will provide you cash in exchange for the remaining balance on the invoices — minus another 10 to 30 percent as security. It's fast money, but it can add up to a hefty price for funds you expected to collect anyway, in as little as a month.
The real cost, however, can be much less, and depends in large part on the reliability of your customers. If they pay their bills, the factoring company will return most of the collections to you, creating a cost of as little as just the 1 percent to 5 percent factoring fee. At an annual rate, that's still expensive money — pricier than a line of credit, but cheaper than many other business loans or business credit cards.
The specific fees for your factoring financing and the size of the upfront discount depend on your industry, the length of time until the invoices are due and the credit histories of your customers. There are some nonrecourse agreements, in which the factoring company assumes all of the risk that the invoices will go unpaid, but that’s rare. For the most part, if your customers don't pay, you're on the hook for compensating the factoring company.
As with any financing transaction, it pays to have good legal advice and read agreements carefully. In invoice factoring, pay particular attention to the fee structure. The factoring fees are often charged monthly — sometimes weekly — which means that you could end up making regular payments to the factor for fees based on the amount of late payments from your customers.
For all of the potential drawbacks, invoice factoring has the advantage of being a fast source of funds. Factors will do some investigation to make sure your invoices are real and your customers can be expected to pay their bills, but most say they will make a decision in days, rather than the weeks or months it can take to land a business loan.
Also, you are able to depend on an often overlooked asset — your accounts receivable — to back up the financing, instead of pledging your business' property and equipment, or your own personal funds.