Small Business Finance >> Factoring Companies
Business Invoice Factoring Explained
by Brandon Cornett
Summary: In this lesson, we will discuss invoice factoring companies and how they can help small business owners turn invoices into working capital (for a hefty fee).
Do you use an invoicing system as part of your business? Do you often have a lot of money tied up in the form of outstanding invoices to customers? If so, a factoring company could help you convert those invoices into some much-needed working capital. But as with every other type of small business financing, there are certain pros and cons associated with this service. So before you pursue invoice factoring as a financial tool, you need to do some homework.
How Factoring Works
Business invoice factoring is a form of accounts receivable financing (also referred to as A/R financing for short). Here's how it works. Let's say I run a landscaping supply company. At any given time, I might have a lot of money tied up in invoices. I sell the supplies to commercial clients, and I invoice them after the fact. It's a common way of doing business.
Let's further assume that I operate on a fairly tight budget. One month, I find myself in a bind. I have some unexpected operating costs that are pending, and my current capital is not enough to cover it. If only there was a way to liquidate some of my invoices within the next week or so. This is where business invoice factoring comes into the picture. Basically, I would sell some or all of my outstanding invoices to a factoring company, who would in turn advance me 80% - 90% of the total amount due.
Later, when my customers were ready to pay their invoices, they would send payment to the factoring company instead of me.
So what we have here is a way to turn invoices into working capital, in short order. But you'll pay a price for this kind of financing, and it can be pretty steep. The factoring company or "factor" takes its fee from the 10% - 20% held from the advance (either as a flat fee or a percentage, based on how long the invoices are outstanding). And they might take up to 40% of the total value of receivables, when all is said and done.
As far as the fees go, it's almost like the commercial version of a payday loan — both services are aimed at people / businesses who desperately need cash. Another similarity with payday loans is the fact that invoice factoring is used by people who have no other choice (i.e., they cannot obtain credit through other channels).
Pros and Cons of Invoice Factoring Companies
We have already addressed some of the advantages and disadvantages of this business financing method. So let's summarize some of the pros and cons we've discussed, as well as those we have not.
- Pros - The most obvious advantage to business invoice factoring is one we have already discussed. You get quick access to working capital. It can also be an open door to financing when traditional commercial lending channels don't work for you. Lastly, factoring can relieve some of the time-consuming burden associated with accounts receivables (collecting, tracking, calling and emailing, etc.).
- Cons - The key disadvantage is the cost associated with it. You can expect to pay more in financing fees than more traditional lending channels. And if your customers typically take a long time to pay their invoices, the cost could increase even more.
This article is by no means an all-inclusive lesson on invoice factoring companies. This is just a general overview to help you understand how factoring works, as well as the pros and cons associated with it. If you are seriously considering this type of small business financing, you should continue your research beyond this website. Seek information from a variety of sources, particularly those that are unbiased in nature (i.e., not factoring companies).
