What Exactly is Factoring?
There are many ways to get cash for your small business. If your clients often owe you money on invoices for significant periods of time, invoice factoring can be a great option for you to consider.
Factoring is appealing because it gives you an advance on the money you’re already owed, so you don’t have to wait for your clients to pay you before you can cover your own bills and employee salaries. Here’s how factoring works:
A factoring company will typically give you around 80% upfront of the value of your outstanding invoices, holding the rest as a “reserve” until your clients have paid their invoices to the factoring company. Once the invoices have been paid, you’ll receive the remainder of the money, minus a fee of 2 – 3% of the total value of the invoices.
Let’s look at an example: you run a consulting company and your clients still owe you $50,000 on invoices you’ve recently sent them. A factoring company would give you $40,000 right now, which means they only kept $10,000, or 20%, as a loss reserve. Once your clients have paid the factoring company the $50,000 owed on those invoices you sold, you’d receive an additional $9,000, so that in the end, you were paid $49,000 and the factoring company keeps $1,000, assuming a factoring fee of 2%.
With regards to the process, you should know that the first time a factoring company makes you an advance, it’ll need to get a better understanding of your clients to ensure they’re likely to pay the invoices. This means that only the first advance takes longer to receive than subsequent advances. The good news is that once your clients are “on the books,” all future advances can be made within just a day or two after submission of relevant invoices to the factoring company.
Factoring can have some downsides. For example, the fees associated with factoring are often higher than those on more traditional small business loans. Additionally, you may feel less comfortable with having a third-party company collecting on invoices from your clients.
That said, a big advantage of factoring is that you won’t suffer from the cash flow crunches that are typical as a business grows. Another bright spot with accounts receivable factoring is that it gives you access to funds quickly and without the excessive hassle associated with many other small business loan options. Finally, it doesn’t require you to put up collateral, because it treats your accounts receivable as the collateral on the loan.
Invoice factoring could be a great solution for your cash needs. As a small business owner, the best thing to do is to learn about your options to figure out which type of loan is right for you.
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