2023 Guide to Invoice Factoring for Small Business Owners

Cash flow is the lifeblood of a business. Companies won’t have the resources to meet their regular cash spend for day-to-day business operations without proper cash flow management. In fact, 82 percent of businesses go into bankruptcy because of poor cash flow management.

There are many reasons why a business may need help generating enough cash despite having many of its financial metrics on the positive. One primary reason is that you may have allowed many creditors too much credit, or you are having difficulty collecting payments from several huge creditors. This dilemma is common among many businesses because extending credit terms attracts more customers without adequately assessing its own liquidity from the get-go.

With cash flow problems on the rise, businesses are turning to invoice factoring for a breather. In this article, we will discuss invoice factoring, how and why it works, and the pros and cons it brings to your business.

What Is Invoice Factoring?

The premise behind invoice factoring is simply increasing your cash flow by ‘selling’ your existing invoices to a third-party ‘factorer’ at a discount.

This means that if you have too many invoices and a lack of cash, you can convert these invoices into cash immediately through a third party, who will collect the payment from your customers.

A factor typically gives you 80 to 90 percent of the invoice financed, less applicable fees.

Accounts receivable factoring can also be used interchangeably with invoice factoring because invoices are all made on credit or recorded as accounts receivable in the company’s books.

How Does Invoice Factoring Work?

To illustrate invoice factoring with sample figures and amounts, consider the following situation:

Company A sold ten pieces of computer units at $1,000 on credit. Terms are that these are payable 30 days after the delivery of the units.

Assuming that Company A has experienced economic difficulties before the 30-day due of the invoice, is tight in cash flow, and is looking for ways to generate immediate cash flow to sustain business operations.

1. Step 1: Company A contacts a factoring company to ‘sell’ the invoice worth $10,000 for immediate cash.
2. Step 2: Set up an account with the factoring company and draft a factoring agreement, getting into detail the scope, amount, and fees of the contract.
3. Step 3: Factoring company conducts due diligence on the invoices to be factored, the invoice’s validity, and the customer’s capacity to pay.
4. Step 4: The factoring company provides Company A a copy of the final factoring agreement to buy your $10,000 invoice for $9,800 (less a factoring fee of $200), which you will receive 80 percent of immediately.
5. Step 5: After signing, the factoring company gives Company A cash of $7,840 (80 percent of $9,800).
6. Step 6: At this point, the factoring company is responsible for collecting the payment from the creditor through a notice of assignment (NOA). At, say, 20 days after the factoring agreement, the creditor has fully paid the factoring company, from which the factoring company will then give you the remaining 20 percent of the sold amount, or $1,960.

When Should Small Businesses Consider Invoice Factoring?

Invoice factoring is not a loan. The difference between invoice factoring and a traditional bank loan is that invoice factoring does not take as much time as a traditional bank loan does to process—generally 24 hours—and that your credit record as a company does not generally matter as long as the validity of the invoice and the creditor is verified.

So, if you are a small business struggling with personal and corporate loans due to poor credit scores, invoice factoring may be a good option to acquire a breather for your cash flow problems or use cash for any seasonal offerings that may benefit your company when purchased immediately.

Invoice factoring companies generally cater to most organizations and companies—from merchandising to freight factoring— as long as the invoice’s validity and the creditor’s capacity to pay are verified.

Factoring companies usually examine and consider the following before extending a factoring agreement:

• Value of the invoice
• Credit terms of the invoice
• Credit capability of the creditor
• Risks involved

How to Choose the Best Invoice Factoring Company

As much as factoring companies can consider whether or not to buy your invoices, you first need to choose the best factoring company that will be most beneficial for your finances.

Here are some things you need to consider when choosing a factoring company:

How well does your target factoring company know about your business model? Choose a factoring company that is an industry expert with experience with your industry so they have better knowledge of how financing terms flow within your business model.

Volodymyr Shchegel, VP of Engineering at Clario, says, “Like a puzzle, businesses must not immediately bite the first hand that feeds them. In the same context, choosing a factoring company knowledgeable about your business operations will help give the most benefits and prompt services for your needs.”

Which factoring company will save me the most money? Among your narrowed-down options, compare those factoring companies offering the lowest fees.

How responsive are they? Your decision to opt for invoice factoring came because of the urgent need for money. Thus, the best factoring company should be able to attend to you and get back to you as quickly as possible, and provide you with the funds you need.

How flexible are they? If you are a small business, settling all queries and doubts with the factoring company before signing any agreement is important. Is there any minimum value of invoices you need to sell off? Is there a lock-in period for the factoring agreement? Are there any hidden penalties involved? Is there a maximum amount I can get for invoice factoring?