Glossary of Business Credit Terms

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Invoice Factoring

What Is Invoice Factoring?

Invoice factoring is a financing method whereby a business sells its account receivables (unpaid invoices of customers) at a discount to a factoring company (factor). The factor buys the invoices for about 70 percent to 90 percent of their value upfront. After the customers pay the business, the factor pays out the remaining funds, minus its fee.

How Does Invoice Factoring Work?

Invoice factoring has four components: a business, its clients (debtors); one or multiple accounts receivable (invoices); and a factor. Usually, the factor pays for the invoices in two installments. The first one covers a large portion of the receivables so as to fulfill the business’s immediate cash-flow need; the second one is paid after the clients have successfully settled the invoices.

These are the steps in the transaction:

  1. The business submits details about invoices to the factor to verify if it is eligible for the loan. The factor analyzes how risky the loan would be, depending on the industry and the reputation of the clients, and then it provides a quote.
  2. When business and the factor reach an agreement, the factor provides the monetary advance.
  3. Then, the factor collects on the invoices according to the terms of the invoice.
  4. After getting the payment from the customers, the factor forwards the remaining balance to the business.

Is Invoice Factoring Right for My Business?

Any type of B2B company, in a wide range of industries, that provides a service or product and issues invoices to customers can benefit from invoice factoring. Industries include:

  • Manufacturing
  • Transportation
  • Healthcare
  • Construction
  • Wholesale/import-export/distribution
  • Oilfield services
  • Government contracting
  • Agricultural produce and food products

Other issues may affect whether a business uses invoice factoring. For example, you don't have access to bank financing and you need a short-term infusion of cash for payroll and other everyday business expenses. Invoice factoring would be your option.

What to Consider When You Choose Invoice Factoring

Like any other financing solution, invoice factoring has pros and cons.

Advantages include:

  • Immediate ongoing cash flow: With invoice factoring, a business gets access to funds quickly, ensuring it can keep its operations running without a funding shortfall. In addition, this does not have to be a one-time solution; instead, a business can build a strong relationship with the factoring firm.
  • Better chances of approval: The factor does not emphasize credit, collateral or loan history; instead, the invoices are a form of collateral. Hence, a business would care more about the payment history of its customers.
  • Builds customer relationship: In owning a business, few other responsibilities can be difficult and stressful for the owner. Collection of debts is one such task. When a business hands over this job to a factor, the business has a better chance of maintaining a positive and strong relationship with its customers.

Disadvantages include:

  • Dependency on the customers: To determine if a business is eligible for the loan, the factor will consider payment history of customers in order to evaluate the risks. If the business’s customers aren’t paying regularly, the factor might assume that it won’t get paid either.
  • Liability: The business is still responsible for unpaid invoices because the factor is not a collection agency. In a recourse invoice factoring agreement, a business is responsible for paying those invoices, or trading different invoice of same amount to cover the cost. A nonrecourse agreement, of course, means a business is not responsible for uncollected invoices.
  • Minimal Control: Businesses hand over 100 percent control of the invoices to the factor. Hence, it is crucial for a business to be comfortable with the factor and its practices.

The financial product that is best for a business depends on the business’s financial strength, size and unique needs. Invoice factoring is invaluable for companies of any size. Qualifying for it is relatively quick and simple. The only thing a business needs are unencumbered accounts receivable from creditworthy customers.

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