Cash flow is critical to efficient business operations, but several hindrances can crop up. Unpaid invoices are common challenges that hinder cash flow, so many small business owners lean towards factoring. But what is factoring, and what is the role of factoring companies? Here’s what you need to know about factoring and factoring companies.
What is Factoring?
Factoring is one way to finance your business expenses. Rather than pursuing a loan or a line of credit, factoring enables you to get cash quickly. Factoring, or invoice factoring, means you sell your outstanding invoices to a factoring company, giving you cash immediately.
Generally speaking, a factoring company will directly pay you between 70% and 80% of your accounts receivable (sometimes up to 93%) and give you the remaining balance minus their fee once they collect the payments.
How do factoring companies work?
Factoring companies, also called factors, are the financial institutions that purchase your outstanding receivables. Here’s an overview of the factoring process.
Step 1: You approach a factoring company and explain your situation. Typically, a company seeks invoice factoring due to a lack of cash flow. Due to net 30 or 60 accounts (or customers not paying), businesses can occasionally run into trouble with cash flow.
Step 2: The factoring company evaluates your situation and decides. Typically factors base their decision, at least in large part, on the creditworthiness of your customers with outstanding balances. After all, the factoring company needs to have some guarantee that it can collect the due balance.
Step 3: If approved, you and the factor will agree on terms and fees. As mentioned, the factor will pay up between 70% and 93% of the outstanding balance. Then, once the factor receives the accounts receivable payments, it will pay you the remaining balance minus a fee. This fee will typically fall between 1% and 5%. So, if your invoices total $50,000 and the fee is 4%, you’ll pay $2,000 as a fee.
Step 4: The factoring company advances you the agreed-upon amount (generally between 70% and 90%).
Step 5: The factor begins the collection process on the invoices purchased from you. Depending on the number of invoices, this process can be time-consuming, but not always.
Step 6: Once the factoring company receives payment from your customers, you receive the rest of the invoice total minus the fee.
What are the Benefits of Working With a Factoring Company?
Working with a factoring company can benefit new small business owners or owners without business credit. Here are some benefits of working with a factoring company:
- Fast Funding: Factoring provides quick funding compared to traditional financing options.
- Improved cash flow: Since you get your money (most of it) fast, factoring is incredibly effective at increasing your cash flow.
- No collateral needed: Since the invoices you sell to the factor are the collateral, there are no collateral requirements or credit checks (typically)
- Invoice management: Although you remit a portion of your accounts receivable, factoring passes your headaches off to professional invoice management and collections specialists
- Flexibility: Unlike other financing options where you are locked into a specific term, factoring allows you to fund as many or as few invoices as needed.
The Different Kinds of Factoring
It’s worth noting that there are a few different types of factoring, and you should know about them if factoring sounds like an excellent option for you. The different types of factoring include the following:
- Invoice factoring: This is what we’ve been discussing in this article, also known as account receivables factoring. You sell your invoices, e.g., accounts receivables, to a factor at a discount and get cash fast.
- Invoice Discounting: This is slightly different but still uses your invoices. With invoice discounting, you procure a loan for the value of your unpaid invoices and then pay the loan back when you receive payment.
- Invoice Securitization: Invoice securitization is a bit more tricky, but essentially, a business pools its outstanding invoices and sells them as a package to investors in the form of securities. The investors receive regular payments from the collections on the invoices.
- Spot Factoring: Also known as single invoice financing, it allows you to sell a single invoice or just a few invoices for prompt payment, usually within 24 to 48 hours.
Is Factoring Right For You?
Like all forms of small business financing, factoring may or may not suit you. It’s a good option for businesses that need money now and have challenges with cash flow. Factoring can be beneficial if:
- You have extended payment terms: If you offer your customers net 30, 60, or 90 payment plans, this provides flexible payment options, but it’s not so great for cash flow.
- Your sales are cyclical: If your sales are seasonal or cyclical and you need cash, factoring is a quick and beneficial option.
- You have limited financing options: Perhaps you are a new business owner, or your personal credit could be better. You may not qualify for a small business loan or line of credit. If this is the case, factoring may be your best option.
- You don’t want to deal with collections: Sometimes, you just don’t want to hunt down payments. Let a factoring company do the collection process for you so you can stay focused on your business.
How to Choose a Factoring Company
If you’ve decided that factoring is a good option for you, the next question is, how do you choose a factoring company? Well, you should consider these:
- The expertise of the factoring company in your industry
- The factoring company’s reputation
- Terms and fees associated with your factoring
- Customers service
At Midwest Business Funding, the best financial relationships form as partnerships. We come alongside you and help you make the best financing decisions possible. Call us today to discuss how we can help you with invoice factoring.