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What is invoice factoring?

Generally when people hear the word factoring, they think of 8th grade math class. But if you’re in business for yourself and bill your customers, you’ve probably heard of factoring. If not, it’s very important to understand what invoice factoring is. Whenever you bill your customers for payment at a later date, you create an invoice. As your customers pay, you close out each invoice and mark it as “paid”. However should the need arise for quicker payments, you can factor your invoice for cash up front.

What is Invoice Factoring?

Invoice factoring is the process of selling your unpaid invoices to a 3rd party finance company. The finance company is usually called a factor or factoring company. In exchange, you receive payment of the invoice up front. The factor will provide 80-90% of the invoice total up front, and collect from your customer. Upon the factor’s receipt of payment from your customer, they rebate the remaining 10-20% (known as the “reserve”), minus their factoring fee. Factoring fees are generally 1-3% of the invoice value itself.

Is Invoice Factoring a Loan?

Establishing an invoice factoring facility with a factor usually is not a loan. However it’s important to understand the differences between invoice financing vs factoring. In short invoice financing is obtaining a loan that is collateralized by your invoices, and invoice factoring is where your business outright sells any and all claims on the invoice payment to the factoring company. Not only is it important to understand the different types of financing mechanisms, but you should also learn to identify loan products disguised as factoring. If you’re not looking for a product that acts like a loan, make sure you obtain a non recourse factoring agreement with a factor.

Why or When Should I use Invoice Factoring?

Invoice factoring is a great cash flow solution for business owners in need of short term working capital who are experiencing a rapid growth in sales, need to buy new inventory, or simply want to match the timing of their income and expenses. Additionally, as you’re diversifying your capital stack, it’s important that you find funding for your business that fits your needs. For example, if you have a short-term capital need, there is no reason to take on long-term debt or sell equity. You can easily monetize your unpaid invoices for immediate working capital.

Are you new to invoicing? Download our simple invoice template today!

What is an Invoice?

Editor’s note: this article is for new business owners and tailored to those who are starting to earn revenue from clients. This article is very elementary and does not apply to many business owners! But if you’re just ramping up your business and a client says to you, “invoice me”, it’s probably best to act like you know what you’re talking about and agree that you will. But it begs to question if you’re unfamiliar, what is an invoice?

 

What is an Invoice?

An invoice is basically a “bill” you send a customer after you’ve provided them with goods or services. Quickbooks defines it as “a bill for an account between a buyer and a seller indicating what was sold, and how much is owed”, and claims the invoice system is 5,000 years old. Investopedia defines an invoice as “a commercial document that itemizes a transaction between a buyer and a seller. If goods or services were purchased on credit, the invoice usually specifies the terms of the deal, and provide information on the available methods of payment.”

Put more simply, an invoice is the bill you send your customers, requesting that they pay you within a fixed time period, who don’t pay you cash upon the delivery or when you finish your work. An invoice includes information about the service or product delivered, with the due date, preferred or accepted methods of payment, and any special terms regarding payment or discounts.

 

How do I invoice a client?

There are many free services online that allow you to invoice a client with a basic invoice template. Ideally, you should keep invoices very simple so they are easy to understand and identify how much is owed and for what. Having an invoice system in place too is very important. This will require that you label invoices consecutively, i.e. Invoice 001, 002, 003, 004. Invoice numbers should be independent of the customer – meaning you can send multiple invoices to a single customer. Keeping track of invoice is extremely important for a few reasons. First is that it will keep you organized. Secondly, you want to have the ability to track invoices and to whom they were sent in the future (especially when closing out the books at year end).

 

Other Words for “Invoice”

Invoices are also known as “accounts receivable”, “A/R”, or simply a “bill”. Once an invoice is issued to your client, you need to increase the Accounts Receivable account in your accounting system with a simple accounts receivable journal entry. And whatever you do… don’t forget to invoice your clients!

Factoring Invoices: Pros and Cons of A/R Based Funding

Many people who start a business generally are aware of the fact that there are three main ways to raise capital. The first is so obtain money from an investor. The second is to obtain money from a bank (i.e. a loan), and the third is to do it themselves by investing their own money. However depending on the type of business you have, particularly what kind of customers you have and how you bill them, factoring invoices may be the best suited option.

What is Invoice Funding?

Invoices, also known as accounts receivable, are created when a business bills its customer and says “pay me later”. Invoice factoring is when a business sells those unpaid invoices to a factoring company in exchange for up front capital. Invoices are sold at a discount and usually the business obtains 80% of the value. After the business’s customer pays the factoring company the value of the invoice, the 20% rebate is given to the client, less the factor fee.

 

The Benefits of Factoring Invoices

The benefits of factoring invoices are many, and usually far outweigh the costs. Here are the main benefits:

1. Match the timing of income and expenses.

Despite a common misperception that invoice factoring signals a company is in trouble, in most cases it’s actually quite the opposite. Rapidly growing businesses need capital to continue to take on new business. Therefore financing invoices is a great way to match income and expenses, so a business has the readily available capital it needs to take on a new job.

2. Bridge to your busy season.

Many businesses are cyclical and have higher revenue during their busy season. To ramp up for busy season, a business will need capital on hand. Invoice factoring is a a viable solution to closing short-term cash flow gaps.

3. Cheaper than selling equity.

Factoring invoices is a cheaper way to raise money than selling shares of your company to an investor. If you sell shares, you forever give up a percentage of future profits to the investor. If you plan to be in business for a while, that could become very costly as you grow to higher revenue levels. At 1-3% per month, factoring is way cheaper.

4. Safer than a loan.

A true factoring product is what’s known as “non-recourse factoring“, meaning the factoring company takes the risk that your customer’s don’t pay. These deals should never have a personal guarantee involved. This differs from a bank loan, that has liability attached to it if your client’s don’t pay, often times with a personal guarantee.

5. Fast time to funding.

The typical turn around time from your first conversation with a factor until you receive funds is 3-5 days, far faster than a bank.

 

The Cons of Factoring Invoices

Despite the many benefits of invoice financing, there are some negative aspects associated with it.

1. More expensive than a loan.

Factoring companies assume the risk that your customer don’t pay. Because of this increased risk, the price of factoring invoices is higher. You have to ask yourself how much risk you want to take. If you really want the cheapest financing deal out there, you need to be very confident in your customers paying and ok with taking that risk that you will be held liable if they don’t. In that case, look into invoice financing. However, if you absolutely do not want to take that risk, invoice factoring is for you.

2. It could impair your ability to obtain a bank loan.

Factoring companies will take a “security interest” in the assets of your business. At the very least, they’ll take a security interest in the current and future receivables of your business. Therefore it’s important to have the discussion with your factor, to ask if they will “subordinate” if they obtain a pre-approval for bank debt. Most factors will, however you don’t want to get set-up with a factoring facility to satisfy a short term capital need, at the cost of a better long-term solution.

 

We’re Here To Help You

In order to make the best decision for your business, you must thoroughly weigh the pros and cons before proceeding with such an important decision. Contact us today for a free assessment of your financing needs and business strategies to see if factoring invoices is a good fit for you and your business.