What Is Invoice Factoring and How Does It Work?

If you are a business owner, you already know the amount of time and effort you need to spend managing your finances. From billing clients to covering expenses, keeping track of it all is a hard task. All these factors can add up, making it almost impossible to maintain a stable cash flow, especially when clients are running late with payments. And that’s where invoice factoring comes in, simplifying payment collection and stabilizing the cash flow. But what is invoice factoring and should your business try it? 

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What Is Invoice Factoring?

Invoice factoring is a cash flow finance solution where you sell some of your company invoices to a third party. The goal is to improvise the cash flow of your company and stabilize its revenue. In other words, another company will buy your invoices and then proceed to collect the money directly from your clients. It’s worth mentioning that while it was once seen as a last resort, invoice factoring is now a common practice.

How Does Invoice Factoring Work?

As previously established, invoice factoring entails the selling of your company invoices. Basically, your company needs to provide a service or goods to your clients, for which you can invoice them. Then, you can sell the invoices to a factoring company, receiving up to 90% of their total value. Once your customers pay the factoring company, you will be paid the remaining 10% minus the commission fee. 

It’s important to note that the amount of money you will be paid depends on the factoring company itself. Some have high fees but pay you up to 95% of the invoice value upfront, while others have lower fees but only pay you 70-80% before receiving the money from your clients. Additionally, if your clients fail to pay the invoices, the factoring company can take legal action against them.

The Advantages of Invoice Factoring

  • Improving the cash flow: Invoice factoring allows you to get the bulk of your invoices paid immediately. That way, you can reduce the time spent waiting for the clients to pay.
  • An alternative to a bank loan: Since invoice factoring is usually cheaper than bank loans, it is better for short-term funding.
  • Increasing the business survivability: Improving the cash flow using invoice factoring increases the revenue and the survivability of your company. 

The Disadvantages of Invoice Factoring

  • Harming your reputation: Introducing invoice factoring to your business means handing over some of the control over your customers. For example, if the factoring company pursues debt in an aggressive manner, your customers might think twice before working with you again in the future. 
  • Costing your company more money: Depending on the factoring company, you might need to repay it in case your customers fail to pay the invoices. 
  • Requiring a commitment: Most factoring companies will buy the bulk of your invoices, meaning that you can’t sell only a small amount. In other words, you can’t change your mind regarding invoice factoring whenever you want, your company has to commit to it.
  • It doesn’t work for small businesses: Small business invoice factoring doesn’t work because factoring companies prefer to spread their risk as widely as possible. In other words,  they try to avoid companies that have a small customer pool.

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Should You Use Invoice Factoring?

Overall, whether or not invoice factoring is suitable for your business depends on your own goals and expectations. For instance, if your company has a lot of outstanding invoices, you should consider giving invoice factoring a try. Likewise, if you want to take advantage of seasonal business opportunities but lack the cash flow, invoice factoring can help.

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However, before you commit to any factoring company, remember to always research their policies and fees. That way, you can avoid deals that could do your company more harm than good.