Last Updated on December 28, 2022
Invoice factoring can help business owners fill the gap between when an invoice is created and when the customer actually pays. It’s a way of obtaining cash to invest back into your company sooner rather than later, though you’ll want to be wary of extraneous fees and sneaky policies before sealing the deal.
What does factoring invoices mean, and how can it impact your business? In this guide, we explain the advantages and disadvantages of factoring.
How Does Factoring Receivables Work?
Factoring receivables work by providing you with a cash advance for your unpaid invoices. Essentially, you sell client invoices to receive a portion of the owed payment ahead of time, minus fees.
Most companies factor receivables because the client takes too long to pay, disrupting cash flow. Accelerating payment through factoring means they can use the money to grow their business and fund daily operations without going into debt.
What are the Advantages of Factoring?
The main advantage of factoring and invoice discounting is that your invoices are paid sooner. However, invoice discounting provides a loan you must repay, while factoring offers a cash advance.
Whether you’re a small business owner or manage a large operation, factoring invoices can be an asset for your B2B strategy. It offers benefits that other traditional lending options can’t provide, and is a more accessible solution for many businesses.
To help break it down, here are some reasons why factoring receivables is beneficial to a seller:
1) Quick cash for your business
Probably the most obvious reason why people turn to invoice factoring, it provides fast cash to keep processes running smoothly.
There are legitimate reasons why a business owner would need to get access to the fast cash, such as:
- Paying employees
- Settling monthly bills
- Bringing in fresh inventory
- Expanding to a new location
In general, keeping cash on hand means you can say “yes” to a new opportunity, instead of passing it up because you’re waiting for funds to come through.
2) Easier approval than a traditional loan
Getting a loan can be out-of-reach for businesses with limited collateral and a short financial history. However, invoice factoring companies pay the most attention to the credit scores of your customers. That means a faulty or nonexistent track record won’t matter as much when you apply.
3) More flexibility for your clients
Increased cash flow for your company means you’re able to allow customers a little more leeway. Instead of requiring immediate payment, you can give them a month or more to complete the invoice, without worrying about the strain it’ll place on your own business.
4) Limited risk for you
Unlike a traditional loan, which requires collateral, invoice factoring is unsecured. So you won’t need to worry about valuable assets being seized if the customer fails to pay.
5) Helps manage overdrafts
Invoice factoring can help you meet the required minimum balances on your bank account and pay settle your businesses own dues so that you don’t have to risk defaulting on financial commitments
6) Highly accessible
After you initially set up an account with an invoice factoring company, you should be able to receive cash within hours of submitting an invoice. These days, you can usually manage the process entirely online.
What are the Disadvantages of Factoring?
That said, factoring isn’t always the best option for everyone. Be sure to weigh the potential drawbacks before determining what’s best for your business. Here are some of the potential disadvantages of invoice factoring:
1) There’s a stigma
While invoice factoring is, at its core, a business practice like any other, it has a bit of a shady past. Lenders have been known to take advantage of clients with confusing language and dodgy practices, though industry standards have since evolved for more transparent transactions.
2) Reduced profit margins
The factor company basically takes a cut out of each invoice. Even though it can be as low as 1-3%, you’re still losing a bit of income in the long run which may affect your company’s monthly budget.
3) Customers’ credit score could thwart financing
Though the pressure to have good credit is off your shoulders, a factoring company will need to verify your customers’ creditworthiness before taking the invoice. If the rating isn’t up to snuff, your invoice factoring request might be denied.
4) Collection isn’t guaranteed
Just because the factoring company buys the invoice doesn’t mean the customer is guaranteed to pay. In some cases, you might be required to settle the bill if the invoice isn’t cleared.
5) It’s a quick fix for only one problem
If customers are delaying payments and it’s messing with your business plan, it may indicate a more complex problem that needs a different strategy to stabilize things for the long-term.
6) Hidden costs and fees from shady providers
Not all factoring companies are the same, and some will try to take advantage of you. Application, processing, credit check, and late payment fees can add up – quickly. Even if you’re OK with the quoted factoring rate, be wary of additional costs and be sure to conduct thorough research before signing on. Make sure to read the fine print, and ask questions up front.
How much do factoring companies charge? Generally, they charge about 1-5% depending on variables like your factoring volume, invoice size, risk profile, and client credit. If your company factors many invoices and works with trustworthy clients, your fees will be lower.
Invoice Factoring vs Invoice Financing: What’s The Difference?
The main difference between invoice financing and invoice factoring is how your invoices are treated. With invoice financing, you put them up as collateral for a loan. Meanwhile, in factoring, you sell invoices to the factoring company for a cash advance.
Factoring is generally quicker and easier to qualify for because the company will review your clients’ financial profiles instead of yours. However, invoice financing generally has lower fees than factoring.
Business Loans vs Invoice Factoring
While they are both viable financing methods for your company, business loans and invoice factoring have their own uses.
Business loans can take weeks to provide funding, meaning they are better for buying capital goods like equipment and office space. Meanwhile, factoring provides cash advances within 1 or 2 days, which makes it good for solving cash flow issues when clients are slow to pay.
Like any business practice, invoice factoring comes with pros and cons. Carefully consider the why behind your choice. Will it help your company grow and expand? Are you planning on investing the money back into your merchandise or employees?
If your answer is yes, the advantages of factoring likely outweigh the disadvantages. If you’re interested in learning how it may work for you, request your free factoring quote from altLINE with basic information about your business. Find out why our customers trust us over the competition!
Photo by Russ Hendricks
Grey was previously the Director of Marketing for altLINE by The Southern Bank. With 10 years’ experience in digital marketing, content creation and small business operations, he helped businesses find the information they needed to make informed decisions about invoice factoring and A/R financing.