Cash flow irregularities can spell trouble for a business. Invoice factoring is one way you can reduce the problem.
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Loans, lines of credit, crowdfunding, crowdlending, family financing — When it comes to ways to acquire more money to boost growth, few businesses are at a loss for opportunity.
Yet, if your business is struggling to balance its cash flow and you are unenthusiastic to acquire more debt, there is one obvious funding option: factoring.
Invoice factoring is a common financing tool, but it is often misunderstood. To make the most of your experience, you should take advantage of this extensive guide to factoring.
What It Means to Factor Your Invoices
The most important thing to learn about invoice factoring is that it isn’t a loan. Rather, factoring is the sale of unpaid invoices to a third-party factoring company — called a factor — for a slightly discounted rate. Essentially, in one maneuver, you remove the costly responsibility of obtaining payments from your clients while receiving the cash you need to keep your business in operation.
It’s important to note that not every business can participate in invoice factoring. Most factors only do business with B2Bs or B2Gs because business and government clients are easier to track down and more likely to make payments.
Additionally, factors typically only consider businesses that have at least two years of history, which indicates they have a significant, reliable client base. This isn’t to say your brand-new B2C won’t be able to factor invoices; however, it will be more difficult to find a cooperative factor with reasonable rates.
Important Terms of Invoice Factoring
Like any business financial agreement, factoring is laden with industry-specific terms. Before you agree to sell your invoices to a trustworthy factor, you should get comfortable with some of the most common factoring jargon:
· Account creditor/client.
This is you! By purchasing services from a factor, you become their client.
· Account debtor/customer.
This is your client who owes you money.
· Discount fee.
This is the rate subtracted from the value of your invoices as factors do not provide this advantageous service for free. In other countries, factoring is sometimes called invoice discounting for this fee, but in the U.S., discounting is another financial service entirely.
Factors rarely dispense payments for invoices in full. Instead, they will offer you an advance of between 70 to 90 percent of the invoice’s value at the time of the sale, and any remaining value will be proffered after the factor receives payment from your clients.
This is the amount you will receive after your client pays. It’s important to remember that your advance and your rebate won’t add up to the full amount of your invoices; instead, factors will subtract the discount fee from the rebate as a cost of doing business.
Different Types of Invoice Factoring
While each factor might offer a bevy of features in your factoring agreement, there are two primary types of factoring of which you should be aware: recourse and non-recourse factoring. The type you choose will impact how much money you receive, how your clients are treated, and a number of other aspects.
Recourse factoring is by far the most common option. In the event your clients fail to pay their invoices within a certain period, you will be liable for their debts. Because this eliminates much of the risk associated with purchasing your unpaid invoices, it means you are much more likely to get a low discount fee and a high advance.
Non-recourse factoring is less common, but it is also less understood. In non-recourse agreements, you are not responsible for repaying the factor for invoices that were left unpaid due to customer insolvency — but you are typically still responsible for payments unfulfilled for other reasons.
Therefore, unless your client declares bankruptcy within a factoring period, you will probably still have to pay delinquent invoices. It’s not necessarily an overwhelming amount protection, especially considering the lower rates associated with it, but it is valuable to some businesses.
How Factoring Benefits Your Business
Cash flow is easily one of the most complicated systems to manage, especially for entrepreneurs who aren’t finance-minded. Unfortunately, cash flow is also among the most important systems for keeping your business alive, which means you should devote plenty of resources to maintaining a healthy, stable cash flow.
For some businesses — especially seasonal ones — this is simply impossible: Some months will always bring in more cash than others. Fortunately, thanks to factoring, irregularities in cash flow aren’t necessarily the end of your business.
By factoring your invoices, you can have access to the cash you’re owed, helping you balance your cash flow and grow your business, even during dry spells.
Plus, factoring rates are typically calculated using your clients’ creditworthiness, not your own, which means your bad credit doesn’t impact your eligibility or earning potential.