Getting the wrong type of financing can negatively impact your business. It could even put you out of business in some cases. Unfortunately, many small business owners get the wrong type of financing for their companies. It may solve short-term problems but ultimately backfires. This article helps you determine if invoice factoring is the right solution for your company. It covers:
- Do you have this problem?
- How does invoice factoring help?
- Common mistakes
- Is factoring right for my company?
1. Do you have this problem?
Companies that sell products and services to commercial clients usually have to offer payment terms. These terms give the client 30 to 60 days to pay an invoice. Small businesses don’t have a choice in the matter. Most large companies demand getting terms as a condition of working with them.
Offering terms creates cash flow problems for companies with low cash reserves. These companies aren’t able to pay their business expenses while waiting to get paid by their client. These cash flow problems can worsen if the company grows, which is counterintuitive for business owners.
2. How does factoring help?
Factoring improves your cash flow by financing your invoices from slow-paying clients. Instead of waiting 30 to 60 days to get paid, you can factor the invoice and get funds immediately. To learn more, read “What is Factoring?”
a) How does factoring work?
Transactions have a simple structure. The factoring company typically finances your invoices in two instalments. The first instalment, the advance, covers about 85% of your invoice. It is deposited into your bank account shortly after presenting the invoice to the factor. The remaining 15%, less the factoring fee, is deposited as a second instalment once your customer pays on their usual terms. To learn more, read “How Does Invoice Factoring Work?”
3. Advantages of factoring
Factoring your invoices has several advantages over other solutions. The four most important advantages are as follows:
a) Improves cash flow
The solution is specifically designed to improve your cash flow quickly. It allows you to offer net-30 terms or longer while minimizing the impact on your company’s finances.
b) Available to small companies
The solution is available to small and midsize companies, and the qualification requirements are straightforward. Companies must have creditworthy clients, invoices that are not encumbered, and an experienced management team.
c) Can be deployed quickly
Many factoring lines can be underwritten and deployed in a few days. The due diligence requirements are simple, minimizing business owners’ time collecting and assembling information for their lender.
d) Grows as required
Factoring lines have flexible credit limits. They can be increased easily as long as your company works with creditworthy clients and provides quality services. The line is designed to adapt to your growing revenues.
4. Disadvantages of factoring
Factoring has some disadvantages that prospective clients should keep in mind. Here are the two most important ones:
a) More expensive than bank financing
Invoice factoring is more expensive than conventional loans and lines of credit. Consequently, the solution works best for companies with profit margins above 20% and invoices that pay in 60 days or less.
b) Requires customer interactions
Factoring companies need to interact with your customers every so often. Initially, your customer will get a Notice of Assignment (NOA). The NOA is a standard document in the industry that advises your clients of the new payment directions. Additionally, invoices are also regularly verified to ensure they are correct. Invoices are usually verified through your client’s vendor portal. Alternatively, the factor may also send an email to your client’s accounts payable department.
5. Common mistakes
You should use invoice factoring only to solve cash flow problems due to slow-paying clients. Otherwise, you run the risk of making your financial situation worse.
a) Using factoring for the wrong situation
Companies can encounter cash flow problems for a variety of reasons. As explained previously, the problem could simply be due to a low cash reserve coupled with slow-paying clients. However, problems can also occur due to profitability problems, expensive debt, etc. Using factoring for any situation other than cash flow problems due to slow-paying clients won’t help your company. Furthermore, it could make the problem worse.
b) Financing potential bad invoices
Some small businesses see factoring companies as a potential solution to manage clients who pay very slowly – or worse, to manage clients at high risk of default. Most factoring companies should be able to catch these invoices before funding them. However, financing these invoices will likely be counterproductive. For example, invoices that pay very slowly will likely have high financing costs. This cost erodes your profit margins. Additionally, factoring companies may have the option to return defaulted invoices, which can be expensive.
6. Is factoring right for your company?
Factoring should help improve your cash flow if the following are true:
- Main problem is slow-paying clients
- Profit margins are above 20%
- Clients are creditworthy
- Invoices pay on net-30- to net-60-day terms
If you are unsure whether factoring can help you, consider working with an accountant or similar professional to help determine the right solution for your company.
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