Invoice factoring companies can dramatically improve a businesses working capital by making funds available shortly after the invoice is generated rather than when the customer decides to pay.
Invoice factoring companies can provide immediate, short-term funds for companies that are unable to obtain a traditional bank loan. Financing from traditional banks generally requires commercial borrowers to have two years in business and showing a profit. Banks tend to favor loans secured by tangible assets like machinery, inventory, equipment and real estate.
Working with factoring companies, in contrast, are less restrictive. When you sell your invoices - often called factoring - you don’t incur any debt so there are no monthly payments. Plus, you can control your cash flow by determining how much to factor and when. Young, growing companies or those with tax liens - and even bankruptcy - can still qualify for an invoice factoring account. This makes factoring companies a viable source of funding for many businesses.
How It Works
In simple terms, here’s how invoice factoring works: Factoring companies purchase your accounts receivable or freight bills at a discounted rate and issue you a lump sum payment. Essentially, your company sells its accounts receivable or invoices at a lower value for quick cash, instead of waiting the usual 30 to 45 days for the invoices to be paid.
After you deliver your product/service and generate an approved invoice, factoring companies can provide your money in as little as 24 hrs. In essence, working with a factoring company can help speed up your cash flow. The influx of cash can better enable you to meet your financial obligations. For example, you can use the money to increase your working capital, pay bills or taxes, pay up front for equipment or supplies, and even take advantage of early payment discounts offered to you by your vendors.
Typically, factoring companies pay 80 percent of the invoice value upfront. Then they issue the remaining value—minus a factoring fee—once they’ve receive payment from your client. The factoring fee is determined by a combination of the credit worthiness of your customer base, the average terms, the invoice number and size, and factoring volume.
Factoring companies structure their fees in any number of ways, but the rate you pay generally works out to be about three to five percent of the invoice value. Keep in mind that financing fees will fluctuate according to the creditworthiness and performance of your individual receivables. If there’s an extremely low level of risk involved, fees can be as low as 1 percent of the invoice amount.
History of Factoring Companies
Factoring companies have been around for centuries. In the U.S., factoring companies first emerged in the colonies shortly after the British began colonizing New England. At that time, a factoring company was a business or individual that facilitated trade between sellers of goods in Europe and buyers of goods in the colonies.
Factoring companies would “vouch” for the buyer—essentially ensuring the seller in the “old” country that the buyer in the “new” country was creditworthy. In addition to charging a fee for their credit advice, factoring companies became trade merchants themselves and facilitated the sale by acting as the buyer and reseller of goods.
Currently, in North America, the factoring business maintains close ties to the apparel and textiles industries. In fact, an estimated 60 to 70 percent of the North American markets dollar turnover comes from these industries. But many modern factoring companies also specialize in industries such as furnishings, trucking, IT staffing, temporary staffing, nurse staffing and manufacturing. Regardless of the industry, many of the basic services offered by full-service factoring companies have remained largely unchanged. Factoring companies generally offer credit advice to help their clients minimize bad debt, cash advances against invoices and collection expertise.
How Factoring Companies Operate
Factoring companies range from small financial service businesses to large banks. Each company has its own approach to operating. For example, many factoring companies specialize in specific industries or regions. Some may require a certain minimum per invoice or total invoice amount before they’ll conduct business with you.
Regardless of the industry or value of invoices involved, all factoring companies work as middlemen. And they have two basic requirements for qualifying for their alternative form of financing. First, you should have no existing primary liens on your accounts receivable, which means no other company should have a claim on payments when they come in.
Next, your customers must be creditworthy because factoring companies depend on the ability to successfully collect on your clients’ invoices. That means your company's credit history won’t necessarily factor into a decision to approve or deny your account. Instead, factoring companies will primarily consider your clients’ payment history and financial stability.
Here’s a step-by-step example of the process of working with a factoring company:
• You complete an application, submitting essential information about your company and accounts receivables.
• The factoring company does its due diligence and prepares all the necessary legal paperwork. Typically this process takes five to ten days, and some factors may charge an application fee.
• Once you begin working with the factoring company, you’ll prepare your customer invoices and forward them to the company for an immediate cash advance.
• The factoring company will bill the customer and follow up to ensure receipt of payment, handling all the accounting, invoicing and other payment processing responsibilities. (The company likely will verify that you actually completed the work or delivered the products.)
• If everything checks out, the factoring company will advance anywhere from 70 to 90 percent of the value of the purchased invoices.
• Your customers will likely send their payments directly to your factoring company. Once the company receives them, it will electronically send you the "unadvanced" portion of the invoices—minus its financing fee.
Important Considerations When Evaluating Factoring Companies
When evaluating factoring companies to work with, there are a number of important areas you should carefully consider. Of course, the pricing structure is a critical factor. You should consider likely customer payment scenarios and calculate what the total fees would be for the different vendors. Also, compare the deposit or application fees, the advance rate, and monthly minimums.
You also should inquire about how the factor company handles unpaid invoices. Some factoring companies will assume all the risk and not require you to repay them if the invoice isn’t paid within a set period of time. Other factoring companies will require you to repay funds advanced for any unpaid client invoice—plus the factoring charges. And still some factoring companies will allow you to replace the invoices of non-paying clients with invoices from paying customers.
Last, but certainly not least, select a factoring company that provides a high level of customer care. This helps to ensure that your customers will be properly treated. All factoring companies operate differently. That’s why it’s important to do your research and find the best-priced and most knowledgeable factoring company for your particular business.