If cash flow is an issue in your business, then leveraging the money your company has in outstanding invoices can seem like a good idea. Invoice factoring, as the practice is called, is a financing option available to B2B companies. And it works by providing short-term working capital in exchange for selling and assigning invoices to a factor. The factor then advances the business roughly 80 percent of the invoice’s value. And once the invoice is paid, the factor pays the remaining 20 percent (minus fees). It seems like a simple solution, but is it the best choice for your business? In this article we look in detail at invoice factoring so you can decide whether it’s a good fit for your organization.
Uses of invoice factoring
Let’s be clear from the start – invoice factoring is primarily aimed at providing solutions for short-term cash flow problems. Businesses often use it as a way to simplify their cash flow conversion. It is not intended to be used for financing big capital investment projects. There are other loans and financing options available for those situations.
How to qualify for invoice factoring
One of the reasons why invoice factoring is a popular option is because most businesses are eligible. Unlike long-term financing options, credit scores, annual revenues and profitability are not key deciding factors in qualifying for invoice factoring. Rather, eligibility is largely determined by the following:
- Your customers must have good credit scores and they must be established businesses. This is important because the factor will need to be confident that your customers are likely to pay off the invoice.
- In addition, the invoices must be due and payable within 90 days and they must be unencumbered by other loans. And so, if you have another short-term loan outstanding where the same invoice is pledged as collateral, then that particular invoice will not be eligible for invoice factoring.
- And finally, your business should not have a history of serious tax or legal problems.
How much does invoice factoring cost?
The base cost depends on two considerations. The first is the discount rate or factor rate. The discount rate is the actual cost of borrowing the money from the factor and is usually calculated on a weekly or monthly basis. The industry range is .5 percent to 5 percent of the invoice value per month. Many factors have a tiered system of discount rates so the more you factor in a month, the lower your discount rate will be.
The second consideration is the length of the factoring period, or in other words, the time it takes your customer to pay. Discount rates are usually charged on a weekly or monthly basis, so the length of time it takes for the customer to pay your invoice will determine the cost.
The factor may well have additional charges such as an initial set-up fee, collection or overdue fees, perhaps a credit check fee or even a minimum monthly volume fee. And so make sure you check out the schedule of charges before signing up to an invoice factoring arrangement.
Invoice factoring can be a great way to alleviate short-term cash flow problems. It’s not a long-term solution though and there will be a cost to your business to take into account. And so before you opt for invoice financing be sure to carefully consider all the issues before coming to a decision.