Posted on November 08th, 2022

As a small business owner, you can turn your unpaid customer invoices into fast cash with invoice factoring. This financing option is best for businesses owners whose customers are other businesses. Because these customers typically don't pay for goods or services right away, invoice factoring can provide immediate cash for business owners to keep paying employees or other expenses.

Here’s what you need to know about invoice factoring.

What is invoice factoring?

Technically, invoice factoring is not a loan. Rather, you sell your invoices at a discount to a factoring company in exchange for a lump sum of cash. The factoring company then owns the invoices and gets paid when it collects from your customers, typically in 30 to 90 days.

Let’s say you own a hardware store and sell goods to another business, creating a $10,000 invoice. Your customer agrees to pay off its invoice in 30 days, but you need the cash next week to pay your employees. You’ve got a cash shortfall.

You could turn to a traditional bank for a loan, but it likely would require stellar personal credit plus collateral, a physical asset such as real estate that the lender could sell if you default. Or maybe you qualify but can’t wait several months for the loan to close.

So you turn to an invoice factoring company, and it agrees to buy your invoice for $9,700 in cash — $10,000 minus a 3% factoring fee ($300). The invoice factoring company advances 85% of the invoice (or $8,245) within a few days. The factoring company then collects the invoice when it’s due and provides the remaining balance owed to you ($1,455).

The factoring fee, also known as the discount rate, can run from 1% to 5%, depending on the invoice amount, your sales volume, your customer’s creditworthiness and whether the factor is "recourse" or "nonrecourse." The factor type refers to who is ultimately responsible for an invoice that goes unpaid — your company or the factoring company.

If the contract is a recourse factor and the customer doesn’t pay, you may have to buy back the unpaid receivable from the factoring company or replace it with a more current receivable of equal or greater value. If it’s a nonrecourse factor, you’re under no obligation to repay or replace the unpaid receivables, but you’ll likely be charged a higher transaction fee because the factoring company takes on the added risk of not getting its money back.

Invoice factoring is also called accounts receivable factoring.

Invoice factoring pros

• Fast cash: Invoice factoring can provide immediate working capital to help cover a funding gap caused by slow-paying customers.
• Improved cash flow: You can keep loyal customers on longer payment terms but still improve your cash flow to help you grow your business.
• Easier approval: Invoice factoring provides financing to companies that might not be able to get capital from other sources, such as a traditional bank, because of a lack of collateral, poor personal credit or a limited operating history. Typically, factoring companies care only about the value of the invoices you're looking to factor and the creditworthiness of your customers.
• No collateral required: Invoice factoring is unsecured financing, which means it doesn't require collateral — an asset such as real estate or inventory that the lender can seize if you fail to pay.

How are invoice factoring and invoice financing different?

Invoice financing is a bit different from factoring. Instead of selling your invoices to a factoring company, you use the invoices as collateral to get a cash advance and you remain responsible for collecting payment on the invoices.

Original article: Is Invoice Factoring Right for Your Business?