Invoice Factoring Basics
Many businesses that invoice on credit terms experience severe cash flow shortages. There can be a large gap of time between the day the customer is invoiced to the day the check finally comes in.
Invoice factoring is a financial solution that converts outstanding invoices due in 30, 60, or 90 days into immediate cash for your business. A factoring company will typically fund your invoice as an advance at approximately 90% of the invoice amount. The remaining 10%, called the reserve, is held until the invoice is paid in full by the customer. The factoring company receives a fee based upon many variables. This fee is paid out of the reserve once the factoring company collects the amount due.
This article will tell you everything you need to know about factoring services, including:
- What is invoice factoring, and how does it work?
- How does an invoice factoring company charge fees, and what does it cost?
- What businesses qualify for invoice factoring?
- When invoice factoring is a poor fit for your company.
- Invoice factoring advantages and disadvantages.
- How to choose the right factoring company for your industry.
1. WHAT IS INVOICE FACTORING?
Invoice factoring is a form of transactional finance whereby a business sells its invoices for delivered products or services to a factoring company in order to close the cash flow gap. Many businesses do not have additional working capital to finance their customers, but the conventions of their industry nevertheless demand that they offer credit terms to customers.
An invoice factoring service allows your business to monetize current, unpaid invoices into a line of credit that helps you meet expenses, pay suppliers, and cover payroll.
“Invoice factoring” is not a common term. Many business owners have never heard of it. However, you may have heard a variety of other terms including “Accounts Receivable Financing,” “Receivable Loans,” and “Receivable Financing.”
To summarize, a factoring company realizes invoices on credit terms as a business asset that can be used as collateral. Regardless of the term used, at the end of the day a business can get funding that is based on the value of its performing accounts receivable by a bank or a factoring company.
A factoring company specializes in financing only accounts receivable and has personnel with experience who can immediately evaluate the value of the accounts receivables being pledged. This is very important because we will talk later about how to select a factoring company.
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Who is involved in the invoice factoring transaction?
- A factoring company realizes an invoice that has been accepted by a credit-worthy customer as an asset worth funding against.
- A company or supplier needs funding on invoices waiting to be paid for goods or services that were sold on credit terms.
- A credit-worthy customer, known as the “account debtor,” needs to buy on credit terms and accepts paying the factoring company to accommodate the supplier.
2. HOW DOES INVOICE FACTORING WORK?
If you’re generating invoices and offering credit terms to customers for product or services delivered, then you can pledge each individual invoice or all invoices to the factoring company (Factor) for funding. Factoring agreements will vary, but they will describe what invoices will be pledged, as well as how many accounts will be pledged for factoring. The factor will set expectations for each Account Debtor’s (the customer being invoiced) level of funding.
As the company submits invoices to a factor for funding the factor reviews each invoice and ultimately either funds or declines each specific invoice depending upon the agreed-upon parameters. It is typical for funding to occur within 24 hours of submission.
Each invoice is treated as an individual transaction of its own, and the fees are calculated as such. The factoring agreement is usually a seller/buyer agreement wherein the seller (Company or Supplier) is the “Client” who sells its invoices at a discount to the factor (the Buyer). With today’s technology and real-time electronic reporting, the process is simple, efficient, and perceived as a line of credit based on the invoices being generated. Some business owners feel this type of financial solution is like selling all customers on “Cash on Delivery” instead of offering credit terms.
Typical “Factoring Terms” or “Factoring Parameters” are described in the factoring agreement. Here are some examples of terms used in invoice factoring.
- Advance Rate – This is the initial amount of the proceeds that are received for every invoice submitted, usually 80 to 95% depending on the industry’s historic dilution and risk ratios.
- Hold Back/Reserve – This is the amount of the proceeds that are held back to cover any off-sets or chargebacks and discount fees.
- Factoring Fees – This is the discount fee that the factor charges based on what was agreed upon, and is deducted from the hold back/reserve.
- Credit Limit – The initial amount of money the factor assigns to extend to the company or supplier.
- Account Debtor Limit – The amount a factor is willing to extend for each individual customer the company invoices to.
- Recourse – This is the number of days the invoice may be outstanding before it is charged back to the Client. Typical recourse days are 90 days.
3. HOW DOES A FACTORING COMPANY CHARGE ITS FEES?
A factoring company uses variable risk ratios and the cost of the administrative burden to determine the fees that it will charge a company/supplier (Client). A factor has typical overhead costs in personnel that will be responsible for servicing the Client. It also incurs other expenses during the relationship, including Credit Analysis Reporting, Tax Monitoring, Online Software Support and Cost of Funds.
The factor proposes terms to the client based on the evaluation of its performing accounts, credit quality of the account debtors, invoice average amount, average of days outstanding per invoice, industry, dilution rates, and concentration ratios. A typical fee can average 0.5% to 5%, and an advance rate from 70% to 97%, depending on the parameters mentioned above.
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4. WHAT DOES INVOICE FACTORING COST?
Factoring companies can customize the fees. Some are flat rates, and others are tiered out by the number of days outstanding. Some factoring companies charge a one-time fee and an interest rate on the outstanding balance. Others charge a tier; for example, 0.5% per 10 days until the invoice is paid with 0% interest. The average cost of invoice factoring in the current market can go as low as 0.5% to 5% depending on the number of days the invoice remains outstanding, sales volume, invoice size, and industry.
To keep it simple to understand, a factoring discount fee is about the same rate as a Merchant Credit Card Processing fee. If your business accepts credit cards, then you will notice fees on your statement averaging anywhere from 1.5% to 4% depending on the card-holder and the credit card that was used. If your business can afford to accept credit cards, then it can afford invoice factoring.
Many businesses can double sales every other month by offering credit terms and adding new accounts. Imagine selling on credit terms but getting paid like cash-on-delivery for approximately 3% of the invoice amount!
By way of contrast ask yourself how much it costs to turn away business. If your business averages a net profit of 10% and you turn away business due to a lack of working capital, then you just lost 10% of your profits instead of the 3% factoring fee. Not to mention you lose a host of other benefits, such as taking advantage of any early payment discounts offered by your own vendors, and the ability to extend credit to good quality customers.
So here’s the real question. Does invoice factoring cost money, or does it make money?
If you’re going to increase sales and expand your business but are limited in your ability to self-finance your accounts receivable, then invoice factoring should make money. If you cannot afford to sustain customers on credit terms, eventually it will cost you money, or you will lose your business.
5. WHICH BUSINESSES QUALIFY FOR INVOICE FACTORING?
Qualifying for an accounts receivable financing program is simple. Most companies that sell on credit terms will be approved. However, there are some basic qualification parameters that you should be aware of.
- A business must sell invoices on net-30, net-60, or net-90 credit terms. Terms that are longer than 90 days are unlikely to be eligible for funding, though there are some special cases.
- The account debtors must have good credit with a long payment track record. Each account that you plan to factor is assigned a credit limit by the factoring company. This limit may be adjusted as needed.
- A business must have a good corporate structure, and make sure all documents related to service agreements, insurance, tax information and invoices match the Articles of Incorporation. If you bear the name “J & B Towing Company, Inc.” on the Articles of Incorporation then your invoice must not read “James and Boyd Towing Company, Inc.” This discrepancy would create an invalid invoice that cannot be pledged as collateral.
- The business must be free and clear of any UCC filings that are encumbering the “Accounts and Proceeds.” A bank loan usually has a 100% blanket lien on all assets. In some cases we are able to fund with IRS tax liens. There are some solutions for these situations that can be addressed on a case-by-case basis.
- The owners must have a clean criminal background. Credit scores are not deal-killers in factoring arrangements for most factoring companies.
- The account debtor will need to at least acknowledge that the invoices have been pledged. The factoring company’s address will need to be updated as the payment address.
- It is preferred to factor invoices for companies that have recurring business with the same account debtors. It takes some initial work to set up the program. Usually, a one-time sale to one account debtor is not appealing to a factoring company. This is referred to as “Spot Factoring” and it’s rare.
6. WHEN INVOICE FACTORING IS A POOR FIT FOR YOUR COMPANY.
Not all companies will qualify for an invoice factoring service due to the nature of the industry, or the types of clients that are being sold to. Sometimes the risk is just too high for factoring companies to consider. Here are some examples.
- A company that has no sales on credit terms has no collateral to offer.
- Some factoring companies allow a start-up to set-up, but they must come up with some invoices to fund relatively quickly. Otherwise the factor will incur monthly monitoring fees to maintain the new start-up in the portfolio.
- Invoices with no backup, combined with an account debtor that will not verify verbally or by e-mail.
- Account debtors with no payment history, slow payment reporting or a poor financial status will not be eligible to factor. It is important to sell to credit-worthy accounts if you plan to factor invoices. On another note, if you are selling to non-credit worthy accounts it may be only a matter of time before you take a loss.
- A company that sells retail only.
- A company that only generates revenue based on commissions.
- A company in a deteriorating industry with account debtors who are lining up for bankruptcy.
- A company with sales agreements full of contingencies. For example, a major retailer will reserve the right to offset slot fees, charge-back liquidation fees, offset any returns against future invoices, paid-when-sold or paid-when-paid clauses are a deal-killer for many factoring companies.
7. INVOICE FACTORING ADVANTAGES AND DISADVANTAGES
Financing invoices can be very beneficial. While all companies have different problems most problems do revolve around cash flow shortages due to extending credit to customers.
Below, you’ll find a comparison between invoice factoring and bank financing.
What are the advantages of factoring?
- 3 to 5 Day Account Set-Up – A factoring company can set up a client in approximately 3 to 5 days.
- Start-up Business Approved – Factoring invoices is a transaction type of finance, so there is no need to review financials, debt ratios, sales histories or other typical underwriting parameters that you’d see used in the banking world.
- Fast Approvals – Prequalifying a factoring client is very simple and straightforward. Usually, a client can get pre-qualified in one hour and get the initial funding in 3 to 5 days. Once the client is set up, funding usually occurs within 24-hours of submitting an invoice.
- Higher Credit Limits – A credit limit is not established based on past history or debt-to-income ratios like a bank. An invoice factoring company establishes the credit limit based on based on the credit-worthiness of the account debtors rather than the client’s ability to pay. The client will request an estimated credit limit for each account based upon what will be needed in the future.
- Credit Analysis – One of the services offered is advising the client of credit risks for each account. A bank offers no credit risk reporting or analysis of accounts.
- Opens Up Additional Financing Alternatives – Once a factoring company establishes a relationship, other additional financial products may become available to that client. These include purchase order financing, inventory financing, and/or letters of credit to vendors.
- No Financials Required – Financials are typically not required under $350,000, but this may vary from factor to factor. This is a huge advantage, since most small businesses do not have full-package financials.
- Location is No Longer an Obstacle – Banks require regional locations and physical visits. Setting up a factoring relationship is a phone call away and you can do it from any location in the country.
- No Audits – Banks need to send an auditor. The majority of factoring companies do not require audits unless you’re requesting a substantial amount of money.
- Instant Access to Deposited Checks – Checking accounts can take up to 3 business days to credit your account. Factored invoices are immediately available because the funds are wired or deposited into your checking account via ACH.
- Invoice Factoring is Not a Loan – When a company submits an invoice for funding the invoice itself is an asset. The factoring company is simply purchasing the asset at a discount. The client who issues the invoice is the seller, and the factoring company is the buyer. The transaction is treated like a purchase and not like a loan. The balance sheet shows cash on hand. It’s not a liability that must be paid back like a bank loan, as if the transaction were a cash-on-delivery sale.
- International Receivables – Foreign receivables become eligible when you use an international factoring company.
- Credit Scores – Most factoring companies do not make approvals based upon the personal credit score of business owners. Decisions are heavily weighed on the quality of the account debtors and on having clean paperwork with back-ups.
What are the disadvantages of invoice factoring?
No solution is perfect, and invoice factoring does come with some disadvantages you should be aware of.
- Factoring Company Interaction – There will be more interaction between the factoring company and the account debtors. Clients sometimes feel uncomfortable about this at first. After awhile it usually becomes “business as usual.”
- Discount Fee – The fee is more expensive than a bank loan. However, the fee is based on every transaction, and is only charged when a transaction takes place.
8. HOW TO CHOOSE A FACTORING COMPANY FOR YOUR BUSINESS
There are many attributes you should look for in choosing the right factoring company for your business. A successful factoring company should have experts who analyze credit data on a daily basis, a professional staff to follow up on past-due invoices, a minimum of 5-years in business, a staff that understands your industry, financial backing, and up-to-date technology that keeps their customers informed through the use of real-time data. The following tips may be used as a “Factoring Company Buyer’s Guide.”
- Does the Factoring Company Have a Credit Department? – A factoring company needs a professional staff that understands credit. Poor credit decisions may expose a company to inappropriate levels of risk. On the other hand, a factoring company that lacks an understanding of account debtor credit may unnecessarily restrain your company’s ability to grow by failing to approve higher credit limits when necessary.
- Does the Factoring Company Have a Collections Specialist? – Factoring companies are not a collection agency. Rather, they act as an extended arm of your company who follows up on invoices that have not been paid according to your terms. Checking on the status of invoices is part of the normal course of business, especially if the invoices are past due. It is important to find out early if there are issues holding up payment. This will save the client money on fees.
- How Many Years Has the Factoring Company Been in Business? – Longevity in the industry increases the chances that the factoring company will still be around in the future. Young factoring companies may require additional seasoning. They may also lack equity for leveraging losses or the ability to maintain a consistent staff.
- Is Industry Specialization Important? – This is very important, and you should ask many questions. Test the factoring company you are talking to by using terms that are only used in your industry. For example, if you are a trucking company then you need a Trucking Factoring Company that specializes in servicing fleets. Services typically offered for trucking companies include fuel advances, fuel cards with the ability to deposit directly into a fuel account, and online credit checks for freight brokers.
- Online Access – It is very important as a client to have 24/7 access to online reporting on your account. Some factoring companies are still not technologically up-to-date.
- Hidden Fees – Ask about any other fees that are not mentioned in the initial proposal. Ask for the terms of the factoring agreement so you can evaluate them before taking your next steps. Some factoring companies begin charging fees from the date of your invoice, rather than the date of funding. This will cost you more in fees, so make sure you check before making your final decision.
1st Commercial Credit, LLC is a factoring company with over 15 years in business, specializing in funding receivables for small-to-medium size businesses, including temporary staffing firms, trucking companies, manufacturing and service providers.
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