If you are a B2B business then you know that giving attractive credit terms to your customers is one way to grow fast. But for many small businesses, they face a dilemma: How to extend credit when they can barely make ends meet? One answer is invoice factoring — that is selling the value of your unpaid invoices to get cash today. This article will take a deeper look at what invoice factoring is and how it will help you in a competitive market.
A Quick Lesson
In its simplest terms, invoice factoring is selling your account receivables to a finance company. In turn, you will receive a large percentage of the invoice’s value immediately. This allows a business to extend credit lines to their customers while being able to cover their working capital needs.
However, there is a cost to factoring and it is usually best suited for large purchase orders or customers who have an established credit history. This reduces payment risk and makes it easier for the finance company to approve payment.
In addition, factoring for cross-border sales can be tricky — but not impossible — and if you are a small company with export customers you want to make sure you find a lender who can help you finance these transactions.
Selling your accounts receivable to a finance company allows you to collect cash on invoices not yet paid — especially those on credit terms such as net-60 or net-90.
While account receivables are considered assets, the reality is that can also be a bit of a drag on cash flow as well. This is because accounts receivables in their purest form are extremely illiquid — that is they are difficult to turn into cash.
If you are running a small business, then you know that cash flow is usually the biggest problem to growing your company. Invoice factoring is one way to overcome this challenge.
This sounds like a perfect solution, but remember that invoice factoring does not come for free. There is a cost associated to getting paid early, and depending on the risk it could be quite hefty.
Even if you are giving up some of the profit on your sales, factoring can help you boost your cash on hand. For this reason, factoring is a good way to help grow a business fast. This allows you an opportunity to grab market share and win in a competitive market.
What Are the Advantages
As mentioned, the biggest advantage is the ability to get paid fast — in some cases, within 24 hours, though a first-time customer might require a week or two.
Another advantage of factoring is that it is not debt. Yes, finance companies usually handle factoring, but they are not providing loans. Instead, factoring is considered an asset sale. As such, your debt service ratio will look better on your balance sheet and this will allow your company to access additional financing from other sources in the future.
In addition, you won’t have to worry about collections when you factor — especially if the agreement is non-recourse. This type of factoring means that the finance company is purchasing all the rights, and liabilities, associated with the invoice. As such, you have no risk if the underlying invoices were to go unpaid.
While non-recourse factors tend to be more expensive, they can be a big help for a small company as the cost of collections can often be more than the cost of factoring an invoice. Compare this to recourse factoring which usually has lower fees but it also comes with the agreement that you will buy them back if the invoices go unpaid.
What Are the Disadvantages
While factoring is not treated as debt, there are is a cost associated with invoice factoring. You won’t receive the entirety of the invoice, losing some to fees determined by the factoring company. As mentioned, this will depend on the size of the risk, the customer’s credit history, and whether the transaction is domestic or international.
In addition, factoring could create challenges when dealing with customers. This is because you are selling your invoices to a third party and they will be the ones your clients have to pay. As such, your customer might be getting calls from someone they did not even know was part of the transaction.
As a small business, a good way to get around this is to let your customers know that you will be factoring their invoices. Most customers will understand as they know you are small, but growing business. In fact, some of your customers may even be using the same finance company to factor their invoices.
Help You Win in a Competitive Market
For most small businesses, the focus in on surviving; this makes sense, especially in the beginning. However, long-term growth depends on getting out of survival mode and factoring provides the opportunity to focus on what you do best.