Summary: All forms of business financing involve risk, and invoice factoring is no exception. In this article, we outline the primary risks associated with factoring and provide detailed strategies to mitigate your risk. These strategies will improve your chances of success. We cover the following:
- What is invoice factoring?
- Is factoring risky?
- What are the risks of factoring?
- How to minimize the risks
1. What is invoice factoring?
Invoice factoring allows companies to finance their invoices. It is used by companies that need to improve their cash flow.
Most business clients typically pay their invoices in 30 to 60 days. However, these payment terms can create cash flow problems for some companies.
Factoring solves the cash flow problem by financing your accounts receivable. This transaction provides immediate funds you can use to operate the business. Factoring plans have simple qualification requirements and can be deployed quickly. Read “How does factoring work?” to learn more.
2. Is invoice factoring risky?
Invoice factoring is a low-risk solution, provided you use it in the right circumstances and work with a reputable provider. In our experience, the biggest risk of factoring is using it incorrectly.
There are several reasons why a company can encounter cash flow problems. These include slow-paying clients, declining sales, and low profit margins, among others.
However, invoice factoring can only address cash flow issues caused by slow-paying clients. Using factoring to solve other problems won’t be effective and could be counterproductive.
A simple and effective way to reduce the risk of using factoring is by answering the following five key questions. If you answer ‘yes’ to all of them, then factoring should work well for you.
- Can my cash flow problem be fixed with factoring?
- Do my customers have good business credit?
- Do my customers pay within 90 days?
- Are my profit margins high enough?
- Is my company free of major problems?
3. What are the risks of factoring?
Using a factoring program can carry some risks. While most of these risks can be mitigated through due diligence, it is essential to be aware of them. These risks fall into the following five categories.
a) Higher than expected costs
Factoring clients can face higher-than-expected costs for several reasons. The most common reason is not understanding how their factoring company prices its services well enough. Consequently, they are surprised when their cost statements. Additionally, reasons for higher cost include:
- Customer defaults
- Customer payment delays
- Default contract clauses
b) Customer perception
Factoring requires some involvement by your clients. The level of involvement varies by transaction and depends on your circumstances. However, this can lead to negative perceptions if not managed correctly.
c) Magnifying existing problems
Factoring is designed to fix cash flow problems created when companies offer net-30 terms to their customers. Generally, that is the only problem that can be solved with factoring.
Using factoring to solve other types of cash flow problems (e.g., declining sales, low profitability) will likely exacerbate the issue. This is because your original problem will remain unaffected. However, your company will need to cover the financing cost of using factoring.
d) Aggressive providers
Some factoring providers can employ aggressive tactics in their dealings with clients and customers. Working with an aggressive provider can impact both your bottom line and your reputation.
e) Long contract terms
Some factoring contracts have year-long commitments. That can work well in many situations. However, it can also backfire. Being tied to a contract that has outlived its usefulness is expensive and counterproductive.
4) How can you minimize the risks of factoring?
There are several steps you can implement to minimize your risk when using factoring. The simplest step to substantially reduce your risk is to work with a reputable provider. They can help you determine if factoring is right for you. Other steps include the following.
a) Use factoring correctly
Many companies make the mistake of using factoring to fix problems it can’t solve. For example, factoring can’t help you if you have cash flow problems due to low margins or decreasing sales. It will only make the problem worse.
Work with your finance team to determine the nature of your cash flow problem. Use factoring only if it’s the right solution for your situation.
b) Manage your cash flow carefully
Using factoring as a substitute for good cash flow management is a common and expensive mistake. Work with your team to implement good cash flow management practices.
Monitor your invoicing and collections workflow carefully. Send invoices promptly after the product is delivered or work is finished. Follow up with clients regularly and professionally to ensure prompt collections.
c) Read and follow your factoring contract carefully
Small business owners are notorious for not reading their factoring contracts carefully. Predictably, they encounter problems if something does not go as planned.
Read the contract carefully, paying special attention to the clauses that deal with pricing and contract termination. We suggest you review the contract with an attorney before signing it.
d) Understand your costs
Make sure you understand the factoring company’s pricing structure before signing on as a client. The best way to do this is to work through a couple of real-life examples using past invoices. This step ensures that you are aware of all costs associated with the service.
e) Use minimums carefully
Some factoring companies offer preferential pricing if you commit to factoring a minimum amount. Minimums can be an effective cost management tool if you select a minimum that your company can meet comfortably. However, they are a problem if you don’t meet them. Your company will have to cover the difference.
Negotiate a minimum amount that you are certain your company can cover. Otherwise, opt for a no-minimum factoring plan.
f) Develop a customer contact plan
Factoring companies typically interact with your customers at different times. The initial contact happens when they send a Notice of Assignment (NOA) to your customer. This letter explains where to send payments.
Subsequent contact occurs when invoices are verified, though this is often done through your customer’s vendor portal. Lastly, some factors contact your customers when payments are late.
All customer interactions are handled professionally to minimize any potential negative impact. However, the best approach is to work with the factoring company to develop a communications plan that works for you.
g) Check your provider’s reputation
The factoring industry is no different than other industries. Some providers offer excellent services, while others leave much to be desired.
Working with the wrong provider will impact your business. You can minimize this risk through some due diligence.
At a minimum, interview the prospective factoring company carefully. Request three or four references and contact them to gather their experience with the provider. For more information, read “How to evaluate a factoring company.”
Looking for invoice factoring?
We are a leading provider of invoice factoring. If you would like a quote, fill out this form or call us toll-free at (877) 300 3258.
Marco Terry is the Managing Director of Commercial Capital LLC and has over two decades of experience in asset-based finance. He has worked with small and mid-sized companies across the United States, Canada, and Australia. Marco holds a Master of Science in Finance.