Cash flow is the moving force of any business. It determines the financial health of a company by showing how much liquid cash is on hand. However, when you’ve got more money going out than coming in, your cash flow is negative – and that is not a good thing for your business.
All companies need a reliable source that can provide a quick cash infusion when required. And since the accent here is on the word “quick,” one feasible option in these situations is invoice factoring. However, even though it is a popular funding alternative, it may not suit every business.
Invoice Factoring: The Basics
Invoice factoring occurs when a company sells its invoices to a factoring company. But what is a factoring company? A factoring company is an external financing company that purchases outstanding invoices from businesses with slow-paying customers, looking for a way to increase their cash flow.
For example, if you have a growing business that needs capital, the banks won’t lend you money if you don’t have good credit or a long operating history. Likewise, investors aren’t likely to invest in a company with irregular cash flows. Family or friends may not have the money or are reluctant to give you. That means that you are left with limited options. However, like many other businesses, you do have an asset you can sell for immediate cash – your invoices.
Factoring companies purchase your invoices for cash up to 90 percent of the invoice amount. Once the invoiced customer pays the invoice in full, the factoring company remits the balance to the business minus the factoring fee. And since factoring is not a loan but a purchase of assets, you do not acquire debt, and it does not impact your credit score.
Pros and Cons to Invoice Factoring
As with any other type of debtor finance and a financial transaction, invoice factoring has its pros and cons.
Its advantage is that it can provide immediate working capital to help cover a funding gap caused by slow-paying customers. This way, businesses can keep loyal customers on longer payment terms but still improve cash flow to help them grow. Since factoring companies care only about the value of the invoices and do not require collateral, this financial transaction is submitted for easier approval.
Its disadvantage is that the service can be expensive, hidden fees and late payments can increase the annual percentage rate. Furthermore, because the invoice factoring company may collect on the invoices directly, your business will lose control. Simply put, you cannot know how they are dealing with your customers. There is no certainty the invoice factoring company will successfully collect on your unpaid invoices. That said, if you have a case of recourse factor, the factoring company may require you to buy back or replace the unpaid invoice with one of equal or greater value.
How to Know If Invoice Factoring Is Right for Your Company
A business that issues invoices to another company is a great candidate for factoring because factoring companies rely on the business’ customer’s financial strength and payment history to determine if they will collect on the invoice.
Small businesses, to stay competitive, offer extended payment terms that can stretch receivables from 30 to 90 days. Waiting on payments can cause periodic cash flow shortages, which makes it difficult to continue with operations. Even large businesses can benefit from invoice factoring, for example, when they want to bring on more staff or inventory.
Suppose you want your business to build a strong credit history so you can eventually partner with a bank. In that case, invoice factoring can help you by enabling you to keep paying your bills on time and build a trustworthy record of stable cash management.
Invoice factoring is also an ideal solution for startups and businesses that do not have the assets and history that banks want to qualify for traditional financing.
Ultimately, suppose you do not want to carry any debt on your balance sheet, especially during the early stages of your growth. In that case, factoring can be of enormous help.
For any business set on a growth trajectory, staying cash flow positive is critical. Yet, every entrepreneur knows that sometimes that is not a feasible option.
If your company doesn’t have a cash reserve or is not financially positioned to obtain favorable financing from a traditional lender, factoring can be a reasonably efficient way to accelerate a company’s cash flow. In addition, by utilizing assets that your business already has, you can bridge any constraint you might be facing.