Working capital is often overlooked in favor of other financial metrics like revenue or profit margin. However, businesses—especially small businesses—need liquid capital to help meet production demands.
While landing a big deal might sound amazing for your business, if you don’t have the funds available to support production, you’ll stretch yourself too thin. It’s not uncommon for companies to have large sums of accounts receivable invoices that aren’t accessible. The business must meet its obligations and collect the money from the business before that revenue is actually recognized.
Fortunately, there are options for businesses to access some of the money that’s wrapped up in unpaid invoices—and invoice factoring is one of these options. Learn more about invoice factoring below.
Invoice factoring is the process of selling your outstanding invoices for cash. For example, if you issue an invoice to a customer, they might have 90 days to pay it. That means you won’t get your money for another 3 months.
A factoring business will take your invoice, pay you for it, and then collect the money when the customer pays it. With invoice factoring, your business can get the funds it needs immediately and only pays the factoring company a small fee for the service.
Some people consider invoice factoring to be a loan, but it operates more like a cash advance. The factoring company typically pays the majority of your invoice but not the whole amount.
It’s common for a factoring company to cover around 70–90% of the whole invoice. For example, on an invoice of $2,000, a factoring company would issue $1,400–$1,800 of the total amount. When your customer pays the invoice, you receive the remaining funds.
The factoring business makes money by charging a fee to buy the invoice—typically around 3–5%. On a $2,000 loan, this would be $60–$100. They’ll withhold this amount from the final payment when your client pays the invoice.
The factoring company will take over your invoice when they buy it from you. They’ll work directly with your client to collect payment, which means receivable collections—a frequent headache for businesses—is no longer your responsibility.
With invoice factoring, you can gain access to the cash your customers owe you immediately. You can then use this money to cover expenses related to your business or to fulfill other purchase orders within your business. Because this is not technically a loan, there are no limits to what you do with the money.
An important consideration when deciding whether a factoring loan is a good choice is the lender fee. While some factoring companies will charge small fees to buy your invoice (around 3%) others can take out larger amounts, ranging from 10–15%. In high-risk cases or when you’re working with predatory firms, they might take out 30% of the total invoice as their processing fee.
As a business owner, you need to decide how much you can afford for invoice factoring. At what point will the fees related to the invoice purchase cut too deeply into your profit margins? By seeking the funds immediately instead of waiting for the invoice to get paid, you could end up losing more profits and limiting your growth.
Like all financial decisions, there are pros and cons of opting for invoice factoring. Some of the benefits or drawbacks might weigh heavier on your business, depending on your current situation.
A few pros of factoring invoices include:
That being said, you also need to be aware of the risks you face when opting for this kind of financing. A few cons of factoring invoices include:
The option to use an invoice factoring company depends on the business you use. There are ethical companies that are happy to work with businesses of all industries and predatory factoring agencies that charge high fees and go after invoices aggressively. Do your research before making your choice.
If you aren’t sure whether invoice factoring is right for you, consider the other options at your disposal. For example, invoice financing will use an invoice as collateral and provide you with a loan for the funds. You can remain in control of the collection process and pay back the lender once the money comes in. This alternative could be better for your needs than factoring.
At Lendio, we have multiple financing options for small business owners. Visit our online funding portal to learn about different lines of credit and loans to give your business the working capital it needs. We’re here to help you choose the best loan possible.