Nov 23, 2021What is Invoice Factoring and How Does It Work?
Managing cash flow is one of the biggest issues that small businesses face today. Outstanding receivables are one of the hardest parts of this process to manage. Invoice Factoring has become an increasingly popular way of handling these issues.
What is Invoice Factoring & How Does It Work?
Invoice factoring is a practice where a company "sells" some or all of its outstanding invoices to a third-party as a way of improving cash flow and reducing risk surrounding collections. The third-party factoring company pays a large portion of the invoiced amount immediately and then tries to collect the rest as its profit. There are benefits and disadvantages to invoice factoring, which we'll cover in this article.
An example of invoice factoring is as follows:
- Your company provide goods or services to your customers and sends an invoice
- Your company "sells" the outstanding invoices to a factoring company. The factoring company pays you the bulk of the invoiced amount immediately (typically up to 80-90% of the value) after verifying that the invoices are valid
- Customers pay the factoring company directly. The factoring company chases invoice payment if necessary.
The final step varies based on the invoice factoring company that is used. Some third-party companies collect the balance, collect a fee, and then pay the remaining balance to your company. However, the more common format is that the invoice factoring company fully assumes the risk of collection related to the outstanding receivables. This means that if they can collect the full balance, they get the 10-20% spread as profit.
Advantages of Factoring
- More predictable cash flow – Using invoice factoring allows a company to collect a majority of their receivables up front instead of having to wonder when/if they’ll collect. Using invoice factoring makes business planning and forecasting more accurate and allows a business to take advantage of opportunities that might otherwise be unaffordable. Improved cash flow also creates a level of flexibility that allows businesses to be adaptable to changes in strategy and market conditions.
- Reduces Overhead - Invoice factoring services may also reduce business overhead costs related to collection. While invoice factoring does reduce the total amount of cash that is received from a transaction, it also eliminates the need to pay collections or credit control staff. Invoice factoring may also improve the morale of people working in the receivables department, as chasing payments is often stressful work.
Disadvantages of Factoring
- May not be suitable for certain customer bases – Factoring companies are leery of risky or few amounts of customers. Because factoring companies like to spread their risk as thinly as possible, they may charge a higher fee if customers are consistently not paying on time or if most of a company’s value in its accounts receivable are tied up in a few very large invoices. Some factoring companies may also require additional fees for companies in certain risky industries.
- Can harm customer relationships – When the credit control and collections functions are handed off to a factoring company, customer relationships are also handed off. If the factoring company pursues collection of the receivable in a cold or aggressive manner, a company risks its customers being upset or unwilling to work with the factoring company. Customers may also perceive the involvement of a factoring company as a sign that the business isn't doing well.
Overall, invoice factoring is generally a very advantageous practice for small businesses. Increasing predictability of cash flow can have a lasting impact on a company’s ability to enter new markets, acquire new customers, and ultimately grow into a larger company. As noted in this article, there are several potential disadvantages to invoice factoring. However, if a business is careful about choosing the third-party invoice factoring company that it works with, most of those disadvantages can be mitigated. Please reach out to a representative from Nimbl if you have questions regarding how invoice factoring can be implemented at your company.