Any time you’re operating a business where clients don’t have to pay in-full for orders or services, you run the risk of delayed payments.
Unfortunately, just because you haven’t gotten paid doesn’t mean that all work can come to a halt. You still have orders to fulfill, employees to pay and rent payments to make. But that missing cash can have a crippling effect on your operations.
A recent economic report from Sage found that 1 in every 10 invoices isn’t paid on time, costing small and mid-size businesses around the world as much as $3 trillion a year.
Invoice factoring can help. If you’re struggling to collect funds from clients and aren’t sure where to turn, keep reading to learn what invoice factoring is and how you can use it to make sure that it’s business as usual, even when it isn’t.
What Is Invoice Factoring?
Invoice factoring is an easy way for businesses to get the money clients owe them from unpaid invoices without actually collecting on those invoices right away. It’s not a loan, but it’s also different from submitting an unpaid bill to a collections agency. Instead, you’re selling that unpaid invoice to a factoring company.
When you sell an invoice, the factoring company gives you the money that you’re owed, or at least a large portion of it, right away. Then, the invoice factoring company gets their money when the client pays the invoice. Typically, this occurs within 30 to 90 days.
You get the money that you need to keep your business running, and the invoice factoring company earns a fee based on the amount that they paid you and the length of time it takes for the invoice to be paid.
How Small Business Invoice Factoring Works
Factoring invoices is useful when a business has unpaid invoices from clients that they do expect to be paid, but can’t afford to wait for.
Many businesses have several invoices that they are waiting for payment on, which means that the first thing they’ll need to do is decide which invoice they would like to sell to a factoring services company.
In the eyes of invoice factoring companies, not all invoices are created equal. They won’t buy an invoice that they don’t think is likely to be paid and promptly.
What to Consider When Choosing an Invoice to Sell
There are a few factors to consider as you’re making that decision. The first is the age of the invoice. Newer invoices are usually viewed as more valuable because the chance of the client paying up is higher. If an invoice is only between 30 and 90 days past due, it will be easier for you to sell it to an invoice factoring company.
Another factor to consider is the financial standing of the client who owes the invoice. A larger company with lots of funds will be more likely to make their late payment, while a smaller company might struggle more. However, a large corporation with known money problems will be a major red flag for factoring companies.
The final detail you’ll want to think about when choosing an invoice is the size of the bill due. Smaller bills are obviously easier for clients to pay, making it more likely that the factoring company will get their money.
Choosing an invoice that falls into one or more of these 3 categories can help you increase the likelihood that a factoring company will decide to purchase your invoice and give you the cash you need.
What Happens When You Sell an Unpaid Invoice to a Factoring Company
Once you’ve chosen your invoice and the factoring company has accepted it, it’s time to get your money.
As payment, the factoring company will take a small percentage of the invoice. Usually, that fee is anywhere from 2 to 5 percent of the total unpaid bill.
Then, you’ll receive a portion of the remaining balance right away, without waiting for the client to pay their bill. Usually, that portion is around 85 percent of the invoice’s face value.
The factoring company holds the remaining balance until the bill is paid. This balance acts as protection for the advance company. A fee is then subtracted for every week that the invoice goes unpaid. Once settled, those weekly fees are deducted from the remaining balance owed to you. You’ll then receive this balance in the form of a rebate.
How Do Invoice Factoring and Invoice Financing Differ?
While they sound similar, invoice factoring and invoice financing are two very different financial tools.
Rather than selling an unpaid invoice to a factoring company, businesses borrow against their outstanding accounts receivables. Put simply, you’re using those invoices as collateral. In this scenario, you still own the customer relationship.
You will receive a lump sum advance but remain responsible for collecting your unpaid invoices from clients. You will then pay back your advance (plus fees and interest) once your client pays.
In many cases, processing fees are less steep than invoice factoring, averaging 1 to 3 percent per month, versus 2 to 5 percent.
Invoice Factoring vs. Invoice Financing Example
To better illustrate the difference between the two, let’s take a look at an example.
You’re a wholesaler, and you’ve provided a retailer $8K worth of merchandise. You invoice the retailer with net 30-day terms, but you need access to capital immediately to take advantage of a steep materials discount from your vendor.
In the case of invoice factoring, you sell this invoice to the factor. The factor then follows up with your customer to collect payment on the invoice. When your customer pays, they remit payment directly to the factor. The factor issues you a rebate for the reserved balance, minus fees. In total, you receive 96 percent of the invoice value.
If this were an invoice financing agreement, you, not the factor, follows up with the customer for payment. Your customer remits payment to you, and you, in turn, forward this balance on to your lender. The lender then issues you the reserve, minus fees. In total, you receive 97 percent of the invoice value.
Why Business Invoice Factoring Might be the Right Choice
There are plenty of reasons why your business might find itself a bit short on cash at the end of the month or during certain parts of the year. Sometimes the reason is a drop in sales, either occurring suddenly or as a result of your normal slow season. Other times it’s because of an unexpected expense or emergency that puts a strain on your bottom line.
Perhaps even more frustrating than finding yourself short on cash is knowing that you still have clients who owe you money.
Unfortunately, this puts you in a bit of a sticky situation. Unless the debt has gone for months unpaid and your relationship with your client has deteriorated, pressing your clients for payment might not be the best choice.
Your other option would be to take out a small business loan or a personal loan. But this method can take time, and you’ll need to put up some form of collateral. If you fail to pay back your loan, your credit will suffer and you may lose your collateral, making this a risky choice.
Invoice factoring can help you get the money you need in as little as a day. While you do still have to pay fees, you are not the one responsible for paying back the invoice factoring company, the client is. Understanding what will happen should the customer default and fail to pay will depend on the terms in your invoice factoring agreement. There are generally two types of accounts for invoice factoring – ‘recourse accounts’ and ‘non-recourse accounts.’
If your agreement with the factor establishes a non-recourse account, then it will be the responsibility of the factoring company to seek payment on delinquent invoices. If the customer fails to pay, the factor company loses out, but your company will not be penalized.
If you have established a recourse account with the factor, you can be held accountable if the customer doesn’t pay. You have the option to buyback the invoice or swap it out for another invoice of equal or greater value.
Choosing to Utilize Business Invoice Factoring
Business expenses add up whether your clients pay their invoices or not. Whether you need to pay your employees or a new business opportunity has come along, invoice factoring can be a quick and easy way to get the money you need.