Invoice factoring is ice financic. Hence, the credit control that helps companies release cash from their creditor journal.
Thus, the key feature of this type of accounts receivable credit is it can alter outstanding invoices that are due within 90 days into immediate cash to maximize business operation. There is a factoring company that pays the business in installments.
What is invoice factoring?
Indeed, invoice factoring is an invoice financing. It is designed for businesses that offer payment terms to their customers and has them in the invoice. Consequently, a factoring firm can lend an amount of money against your customers’ invoices. Invoice factor will enable you to to receive the cash value of the invoices immediately. Instead of waiting for weeks or months, you can quickly have money to cover daily operating expenses. In this way, you could still maximize every timeline to expand and grow your business
Usually, the percentage of outstanding credit will indicate the amount of credit that can be available. However, there are factoring terms that will limit to a single large customer.
Moreover, the payments from your customers will be through the bank account of the factoring company. Your customers will know that you are using factoring. After all, there are factoring firms that will offer you to have credit insurance of particular customers or entire sales journal to lessen the risk on the effect of credit default. This process is called recourse and non-recourse factoring.
Risk is one significant consideration if you want to access business financing. Actually, factoring is a low-risk financing mechanism for lending firms. The transfer of risk to the lender to control and ensure your customers pay on time. Often, the lenders favor with factoring for businesses with low turn-over, newly established and new in business trading.
How does Invoice factoring work?
By concept, the invoice financing works when you sell the accounts receivable that will be in due within 90 days to a third party (factoring firm). Cash is quick, and you can continue business operations and grow as plan.
1. You give an invoice to your customer
Once you deliver the services or products to your customer, you will issue an invoice to pay you based on your agreed terms. The term of payment the invoices must be within 90 days.
2. Sell and assign the invoice to a factoring firm
Assuming that you already choose the factoring company, go through the application process and sell the outstanding invoices to them.
The factoring firm will determine if you meet the eligibility criteria. The factoring firm will conduct an assessment to the customers you are invoicing to check if the credits are proper and not risky. If the lending company approves your application, both of you will sign a financing agreement. The agreement will state the initial maximum amount that you can borrow which is also the maximum factor amount of the outstanding invoices.
3. The lending company will pay you an advance
The lending company will give you an advance amount. Significantly, the rate is at 80% of the value of the invoices in a factor. The amount of the advance will depend on the size of the transactions, business, and other risk parameters.
Then, the factoring firm may send a notice of assignment to the client you choose to factor. Sometimes, the lender will ask you to do the notification to your clients.
4. Your customers will pay the factor
Your customers will be accountable to pay within 90 days as per agreed terms of the invoice. The factoring firm will handle the collection of all the invoices. Frequently, the firm will also be asking you for the collection techniques of these clients. The factoring approach will show that there is no significant impact on the customers because everything is just following according to the terms of the invoice.
5. The factoring company will send you the remaining balance less the applicable fees
Henceforth, after receiving the payment from your customers, the factoring firm will give you the remaining balance of the invoice which is called the reserve amount. Eventually, remind yourself that there are applicable transaction fees that the firm will immediately deduct.
Why would a small business consider the use of factoring?
The straightforward answer is to speed up access to funds and smoothen the cash flow.
One of the challenges of many start-up businesses or small businesses is that payment terms for invoices take long. In fact, the customer will not be able to comply with the agreed payment terms. When this event happens, it can lead to cash flow problems.
Hence, the response of the gaps in cash flow is likely on either bank overdrafts or business loans. However, the financing industry in the UK offers alternative financing services.
Advantages of Invoice Financing
- Quick and safe source of money to sustain the cash flow
- Lower time to manage and chasing the late repayments
- Quickly expand or contract with your sales journal
- Less expensive
- On debt collection, factoring companies are more professional and gentle in giving reminders compared to traditional debt collectors
Disadvantages of Invoice Financing
- Can potentially affect relationships with your customer if not explained well
- Fees can be higher. It can effectively work to a small business that can achieve a high-profit margin
- Reduce scope for additional borrowing
- Loss of control to your customers’ credit