Factoring Fundamentals: What Every Business Owner Should Know
Every business owner dreams of taking their business to the next level. But sometimes, these dreams are restricted due to a shortage of capital caused by unpaid invoices.
This is where invoice factoring enters to help these businesses to manage their cash flow for daily operations. Unfortunately, not many people are aware of invoice factoring.
Today, we are going to tell you all the fundamentals of invoice factoring that every business owner should know.
Most people often confuse invoice factoring with business loans, but there is a stark difference between loans and invoice factoring. When a business has accumulated long outstanding unpaid invoices, there is bound to be a cash shortage.
Small business invoice factoring is a form of asset financing that provides short-term capital gains to these businesses to conduct their operations.
The factoring company pays the amount of these invoices to the businesses and then collects the payment from the clients.
Now, the question arises how do these companies function? Invoice factoring company or factor is a third party that pays businesses the amount of their unpaid invoices in installments. It is also known as financing factoring.
80% of the invoice amount is paid in advance and the remaining 20% is paid after successful collection from the clients.
The factoring company also deducts its factoring fees and other charges from the 20% in the second installment.
This factoring system is available only in (B2B) business-to-business and (B2G) business-to-government sectors.
Steps of Factoring
There are five steps of small business factoring which are as follows:
- Invoicing Client: Initially, a business or service provider sends an invoice to the consumer for their services. The invoice period could range from 30 to 90 days.
- Selling Invoices: If the customer has not paid the invoice amount and the business requires capital, they can contact a factoring company and apply for their services. After due diligence, if the company is satisfied with your background checks, you can sign a lawful agreement with the company and discuss the amount you want to borrow.
More importantly, it is crucial to remember that you can only sell invoices that have a due date of less or equal to 90 days.
- Advance Breakdown: The company pays you roughly 80% of the invoices after successful registration. Simultaneously, a legal notice is sent to your clients informing them about the arrangement.
- Client Payment: Then the company collects the payment from the clients and stores it in a custom lockbox which is a unique account for client payment.
- Balance Amount: When the company receives all the remaining payments for the invoices, they issue the rest 20% of the balance minus the factoring fees of the company.
You should also be aware of the different factoring fees situated with invoice factoring to make an informed choice.
- Discount Rate: Discount rate is the base cost of registering with a factoring company and can range between 0.5% to 5% of the total value of the invoices per month. These rates can also differ depending on your industry.
- Origination Fee: Origination fee is the account opening fee that also includes the service charge of the lockbox.
- Overdue Fee: When the company is not able to obtain payment from clients, the user is liable to pay overdue fees.
- Maintenance Fee: This is the monthly charge to be paid to access the factoring services.
- ACH transaction Fee: A standard fee that is charged per transaction of every advance issued to the user.
- Credit Check Fee: These are small scale fees charged to you based on the risk associated with your clients.
Difference from Traditional Financing
Many people equate invoice factoring to accounts receivable financing or invoice financing. Though both are short-term funding options, there is a stark difference in the way they both function.
Accounts receivable financing works on the same principle as a traditional bank loan. It charges collateral and only includes business assets that are associated with accounts receivable.
You also need to submit all of your invoices for that month that have a due date of less than 90 days. In addition, accounts receivable financing charges a collateral management fee that ranges between 1% to 2% excluding the outstanding amount.
There is also a minimum threshold of sales to qualify for accounts receivable financing.
While on the other hand, invoice factoring is a straightforward financing option where the factoring company purchases all the invoices and simultaneously pays you the balance for the same.
Apart from this, the factoring company also handles all the other responsibilities of collecting payments, mail etc. Invoice factoring also gives you the freedom to choose the invoices you want to submit.
Invoice factoring is the best avenue for small businesses suffering from decreased cash flow and are looking to expand themselves. It is also a neat arrangement that resolves the constant need to stay in contact with clients for pending payments.
Remember these fundamentals about invoice factoring that can aid you in your business and save you from expensive loan sharks.