The long wait between invoicing and collection of payments is a common problem for B2B businesses.
Customers, especially large companies and government agencies, expect liberal payment terms.
Although the risk of bad debts is low, your money could be locked up for months. If you have many such slow-paying customers, this can create serious cash flow problems. Invoice factoring can give you the much-needed liquidity at a small cost.
Invoice factoring – how it works
Invoice factoring or invoice discounting is a short-term financing method that allows you to borrow funds against your outstanding invoices. Invoice factoring companies (factors) will pay a large portion of your outstanding invoices as long as your customers have a track record of paying on time.
Factors normally lend only to B2B companies. Your customers must be businesses or government entities. Before you use the service, you have to go through an approval process and sign a financing agreement with the factor.
Once your business is approved, you can present your invoices and the factor will make an upfront payment of up to 90% of the invoice value. This is usually subject to a maximum credit limit.
The approval process is quick and simple. Once the factor has determined that your business is eligible for the service, it will check the track record of your customers to see if they are good candidates for factoring.
The factor will then offer its services according to the terms and conditions of a financing agreement. The agreement will specify your credit limit, the advance percentage, the list of customers whose invoices you can factor, the fee structure and the other terms and conditions.
When you present an invoice, the factor will pay you the advance according to the financing agreement. Depending on its method of operation, the factor may inform your customer by sending a notice of assignment and ask them to pay the invoice to the factor. When payment is received, the factor pays the balance amount after deducting its fee. The fee varies from 2% to 6% of the invoice value.
It depends on the agreed rate and the number of days it takes to collect payment from your customer.
Types of invoice factoring
Although the basic method of factoring is the same, there are some important variations. Understanding these variations helps you select the right factoring company.
1.Notification and non-notification factoring
Most factors operate on a notification basis. This means that once you have discounted an invoice, they will notify your customer and give them new payment instructions. Besides the discomfort of customers coming to know about your financial arrangement, you may also be concerned about the factor pestering them for payment. The solution is non-notification factoring.
Factors that work on non-notification basis often present themselves to your customer as your billing or accounts receivables department. Some factors may not even insist on contacting your customers directly. Instead, they will ask you to open a bank account that they control. You then notify customers to make payment to that account or deposit their checks in that account.
Contract factoring and spot factoring
In contract factoring, the factoring company expects a minimum volume commitment from you. You may be required to factor all the invoices of certain customers or the factor may insist that you discount a minimum number or amount of invoices in a certain period. This can be a disadvantage if you are unsure about your sales volumes. It is also a problem if you want to minimize your use of factoring services.
In spot factoring, there is no minimum commitment. You can choose which invoices to factor. You have the flexibility to use the service only when you really need the liquidity. Spot factoring allows you to keep your factoring costs to a minimum.
Recourse and non-recourse factoring
This aspect of factoring determines what happens when your customer defaults. In recourse factoring, the factor can collect the outstanding amount from you as well as the customer. Most factors use this mode of operation and will expect you to pay up in case of a default.
If you have already used the funds, this can be a problem both in terms of liquidity and fees. Fees will continue to accumulate until the factor receives the payment. With recourse factoring, you should only discount the invoices of customers who pay on time.
In non-recourse factoring, the factor assumes the risk of the invoice not being paid. Once an invoice is factored, the factor can only recover the amount from your customer. Due to the additional risk, recourse factoring usually costs more than non-recourse factoring. The factor will also scrutinize your customers and invoices more rigorously before discounting them.
Advantages and disadvantages of invoice factoring
Invoice factoring gives you quick access to funds than traditional options like bank loans. Unlike other forms of financing, the approval process is quick and easy. The factor pays more attention to the quality of your customers than the health of your finances.
The main disadvantage of factoring is the cost, which is higher than the cost of a loan or a line of credit from a bank. Some people will not be comfortable with the factor of contacting their customers or following up with customers for payment. In non-recourse factoring, there is also the risk of the factor becoming a sort of collection agency, which can have an adverse impact on your business.
Invoice factoring allows you to put funds locked in receivables to more productive uses. It’s a short-term method of financing and costs more than a loan from the bank.
As long as you select the right factoring company and use the service wisely, it will help you tide over temporary cash flow problems caused by slow-paying customers.