Invoice Factoring 101: A Definitive Guide on Factoring Receivables

Invoice Factoring 101: A Definitive Guide on Factoring Receivables

Running a business can be frustrating at times. Financial difficulties may arise every now and then, and sometimes you just don’t have enough cash on hand to shoulder your business’ immediate needs. Not all companies have funding stability, and small business owners may have to deal with outstanding invoices that can take up to 30 or 90 days before getting paid.

One of the most common courses of action when dealing with money shortage due to slow paying receivables is Invoice Factoring. Whether you are just starting out on your business or you are dealing with a particularly difficult financial challenge, you may want to look into Invoice Factoring as a way to address your cash flow concerns.

What is Invoice Factoring?

Invoice Factoring is a type of financing that specifically addresses the cash flow issues of companies who often deal with slow paying invoices. Invoice factoring is in essence a financial transaction that involves three parties: the business owner, the clients, and the factoring company.

Instead of waiting for the clients to pay the invoices, a business owner may sell these receivables to a factoring company, an external third-party financing company.

What does it mean when you “sell an invoice”?

By selling an invoice, a business owner receives immediate cash from the factoring company, which then takes over the responsibility of collecting the payment from the clients. Factoring companies typically give the business owners an “advance” payment worth 70 to 90 percent of the invoice total even before the client has paid.

So say, for example, that a client owes a construction supplier $10,000 worth of invoice that is payable in 60 days. Because the supplier needs some money to purchase more materials for another project, the supplier may sell this $10000 invoice to a factoring company for only $7000.

When the client eventually pays the factoring company the full $10000 amount, the factoring company will give the remaining $3000 to the business owner minus the factoring fees.

In the scenario given above, the business owner is able to secure immediate cash without having to wait for the 60-day deadline. The owner also gets most of the invoice amount, just minus the factoring fees or the discount. These factoring fees go to the factoring company who also makes money from this transaction.

Invoice Factoring – Definition of Terms:

Advance Payment is the first payment that you get upon selling the invoice to the factoring company. This amount is typically 70 to 90 percent of the total invoice.

Rebate is the second payment you get after the client has paid the invoice to the factoring company. This corresponds to the remaining invoice amount (total invoice minus advance payment) minus the fees.

Discount is the fee that the factoring company keeps in each of the transactions. This amount is subtracted from the total invoice and is essentially your payment to the factoring company.

How is Invoice Factoring different from other forms of financing?

Before we go into the more specific details of invoice factoring, let us first understand how this nifty financial tool is different from other forms of financing.

  • Invoice Factoring vs. Invoice Discounting

It’s crucial to understand the difference when it comes to invoice factoring vs. invoice discounting. Invoice discounting operates similarly to invoice factoring. Both transactions allow a business owner to sell invoices to a third-party company in exchange for a discounted price. Invoice discounting, however, does not make the external company responsible for collecting payment from the client — you still have to pursue the client and handle payment collection yourself.

Moreover, invoice discounting is also often done in confidence, which means the client is not made aware that a third party is involved. This may be a good option if you are looking to keep you financial difficulty on the down-low.

  • Invoice Factoring vs. Bank Loans

Traditional bank loans require extensive paperwork before getting approved, and they also take quite some time to process. Construction bank loans may also be restricted to specific uses, so there is limited potential in maximizing the loan amount through other ventures.

However, bank loans are still relatively cheaper than invoice factoring. Interest rates are lower, and the loan amount is given to you in bulk. Bank loans may be the better option for bigger, more established businesses.

  • Invoice Factoring vs. Invoice Financing

Invoice Factoring is also sometimes referred to as invoice financing, but a specific type of invoice financing means using your invoices as collateral for a loan. Instead of selling your invoices, you are instead borrowing money and using your receivables as security.

So if, for example, you are not able to pay the loan according to the terms of the loan agreement, the lender will have the right to claim the payment from your invoices.

Advantages of Invoice Factoring

Other financing methods have their own advantages, but invoice factoring may still be ideal especially for small business who deal with slow-paying clients on a regular basis.

Invoice factoring, for example, allows you to focus on other aspects of your business instead of handling invoice collections on your own. Small businesses often do not have the manpower to assign credit controls and payment collection tasks to a dedicated staff.

Unlike traditional bank loans, invoice factoring is relatively easier to get and does not put you into more debt. Small businesses typically do not meet the loan requirements most banks have, and most lenders consider invoice volumes before loaning out cash.

Disadvantages of Invoice Factoring

The biggest disadvantage of using invoice factoring is its cost — factoring is more expensive that traditional bank loans. Factoring fees may go between 5 to 30 percent.

Invoice factoring is also a temporary solution to a potentially long-term financial issue. It only solves cash shortage issues given that payment may still be expected from outstanding invoices. It may not be helpful for other financial concerns like payment disputes and delinquent clients, but it sure is fairly effective tool in specifically addressing concerns regarding slow-paying invoices.

How does Invoice Factoring Work?

how invoice factoring works

Step 1. Issuing invoices that are payable within 30 to 90 days.

This step should be a standard operating procedure for all business owners. Upon rendering their services (e.g. labor and construction supplies) to the client, the business owner must send an invoice so the clients know how much they owe and when the payment is due.

Most factoring companies conduct credit checks on the clients whom they will collect the payment from. The credit rating and overall reliability of your clients may affect the discount fees that the factoring company will deduct from the invoice total.

Step 2. Selling the invoices to factoring companies.

This step goes two-ways. One, you have to find the right factoring company to sell your invoices to. And two, you have to apply to that factoring company and see if you will agree on the terms of the transaction.

Factoring companies will typically look at your customers’ credit ratings, the number of invoices that you are planning to sell, and the frequency of the transactions that you are looking to enter. The rates that they will offer may depend on these factors.

Step 3. Getting the advance payment.

The factoring company will verify that invoices that you sold them and will then give you the advance payment, typically worth 70 to 90 percent of the total invoice. The advance payment is the first payment, the immediate cash that you need.

Advance payments are usually done via direct deposit to the owner’s bank account. Deposits often take a few days to get cleared in the bank. If you need the money sooner, you may ask your factoring company to send you the payment via wire transfer instead.

Step 4. Settling the invoice with the client.

Each invoice issued are payable within a certain period of time, and at some point the client is bound to settle the payment to the factoring company. When the client has paid in full, the factoring company receives the money and the invoice is settled with the client.

Factoring companies will have a so-called “schedule of accounts” which lists the invoice that you sell them, their amounts as well as their due dates.

Step 5. Receiving the rebate.

When the invoice has been paid in full, you may finally receive your rebate, the second payment that settles your transaction with the factoring company. The rebate is the remaining invoice amount, minus the fees.

Total Invoice Amount – Advance Payment – Fees = Rebate

invoice factoring fees

How to Choose the Right Factoring Company

Deciding which factoring company to choose depends on your needs and the industry you’re in. The following questions may help you pick which factoring company may fit you best.

What type of factoring do they offer?

  • Recourse vs. Non-recourse

Recourse factoring means the business owner is responsible for purchasing back the invoice from the factoring company in the event that the client fails to pay altogether. Non-recourse factoring, on the other hand, does not hold the business owner liable for non-paying clients.

Recourse factoring poses less risk for factoring companies, so the fees are much affordable. Factoring companies charge higher rates for non-recourse factoring, simply because they will lose more money if the client fails to pay the invoice.

  • Spot factoring vs. Full Turn Factoring

Spot factoring is the one-time sale of a single invoice to a factoring company. It is a good option if you are only dealing with a single slow-paying invoice and you need immediate cash right away.

Full Turn Factoring is whole ledger factoring, which means that you are required to sell all your client invoices and engage in a long-term contract with the factoring company. This option charges lower fees than spot factoring.

  • What industries are they working in?

It is highly advised that you work with a factoring company that deals with clients in the industry you work in. Some of the industries that are notable for using invoice factoring are construction, manufacturing, transportation, and oil and gas.

What terms and rates do they offer?

It is also highly advised that you consult multiple factoring companies before settling on one. Compare the terms and rates that they offer and see which options best fit your needs. Signing a long-term contract may be more economically advantageous than selling on an invoice-per-invoice basis.

Do they offer good service?

Obviously all factoring companies will claim that they offer the best service in the market. The best way to find out, however, is to ask for client references. Most companies will give you client references once you submit a formal application and / or a request for proposal. Talking to the company’s actual clients will help you get feedback on how good their service is.

Invoice Factoring for Construction Companies

The construction industry is one of the sectors that benefit greatly from invoice factoring. Construction businesses usually deal with stage or staggered payments and the nature of the debts are usually contractual. Construction companies, therefore, have to meet more stringent requirements to secure financing from traditional lenders.

Invoice factoring also allows contractors and subcontractors to manage a more flexible cash flow and funding for their operations. In an industry where businesses deal with other businesses and payments can be very difficult to collect, factoring can be one of the more convenient financing options.

invoice factoring for construction

Three Ways Invoice Factoring Works for Construction Businesses

1. Stay on top of your operating expenses. Waiting for clients to pay is not an option for most construction companies. Laborers must be paid and materials must be bought to honor a contract, so having immediate cash when needed is very important.

2. Outsource payment collection. Running a construction business is already difficult on its own. With invoice factoring, an external company becomes responsible for pursuing and collecting payment from clients.

3. Secure potential debt from client. Factoring companies offer “non-recourse factoring,” which means that if the client does not pay within the deadline agreed upon on the terms, you do not have to give back the advance payment that you initially received.

Invoice Factoring for Subcontractors

Subcontractors often have to deal with cash flow issues regarding slow-paying invoices. They start doing work and buy materials for a project, but the tiered payment system allows them to get paid only after 30 or 60 days.

In this regard, it may be highly beneficial for subcontractors to look into invoice factoring.

Advantages of Invoice Factoring for Subcontractors

·   Invoice factoring gives subcontractors the money they need before the invoices get paid.

·   Subcontractors are able to establish a long-term contract with a factoring company, which may translate to more affordable rates.

·   The availability of a flexible cash flow can make it possible for subcontractors to expand their business.

Disadvantages of Invoice Factoring for Subcontractors

·   Some general contractors do not allow their subcontractors to factor invoices, depending on the GC’s internal policies.

·   Mechanics lien laws may obligate the subcontractors to pay their material suppliers from the invoice factoring advance payment.

·   Some laws may also prohibit a subcontractor from receiving an advance payment without releasing an existing lien.

Invoice Factoring for Material Suppliers

Material suppliers are another great fit for invoice factoring. Like most small construction business owners, suppliers often have to deal with slow-paying invoices that can take up to 30 to 60 days to clear.

It is quite common practice for suppliers to offer a discounted rate to their clients in exchange for being paid earlier than the agreed deadline. Not all clients agree to this offer, however, and promises of prompt payment do not always come through in practice. Invoice factoring is therefore one of the more reliable financing options a supplier can choose.

Advantages of Invoice Factoring for Material Suppliers

·   Invoice factoring gives the supplier peace of mind because they do not have to wait 30 to 60 days receiving the immediate cash they need for maintaining operations.

·   Compared to traditional bank loans, factoring is much easier to get, especially for smaller businesses who may not meet the minimum financial requirements of most lenders.

·   Invoice factoring helps you improve your financial line as you grow your network of reliable clients. Engaging in long-term factoring contracts will help you maintain a reliable source of cash.

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