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The Small Business Owner’s Complete (and Non-Boring) Guide to Factoring

Small business owners are always looking for new ways to improve cash flow and get ahead of the competition. Invoice factoring is a strategy that many business owners have successfully employed.

No matter what you call it, the idea behind selling invoices remains the same. You sell your invoices or accounts receivable to a factoring company for cash. In some cases, this puts the factoring company in the position of a bill collector. You have the cash in hand, and they are responsible for collecting the money and processing the payments associated with the invoices.

In the end, both sides win. When the factoring company assumes responsibility for the debt, the small business owner doesn’t have to worry about collecting. If the factoring company doesn’t assume responsibility for the debt, the small business owner still gets a cash advance to help them through a tough spot.

And of course, the factoring company realizes a financial gain as well. Here is an example we have shared in the past:

“Let’s say you have a $100,000 invoice with 30-day terms. A factoring company may immediately advance you 85% of that amount ($85,000), holding $15,000 in reserve. The customer then pays the invoice 2 weeks before the due date. After subtracting the 3% processing fee ($3,000), the factoring company would keep its factoring fee, which is 1% per week the invoice was outstanding (in this example that would be 2% or $2,000) and give you the remaining $10,000.”

There are a lot of numbers in that formula, but upon closer review you will realize it is actually quite simple. You don’t get the full amount of the invoice, as some of the money goes to the factoring company to cover fees. What you do get, however, is an immediate advance, as opposed to waiting around to be paid. For companies that need cash flow now, not later, this is just about as good as it gets.

The Finer Details

Just the same as any business decision, you don’t want to decide in favor of accounts receivable factoring until you are 100 percent comfortable with the process and how it will unfold. To ensure that you are on the right track, here are four details you should always remember:

  • Maximum advance amount: approximately 50 to 90 percent of the total invoice amount. For example, a $100,000 invoice would qualify for an advance of $50,0000 to $90,000
  • Repayment. Once your customer pays the invoice in full, the factoring company will subtract all agreed upon fees and you will receive the remaining reserve amount
  • Factor fee. Every factoring company is different in this regard, so pay close attention to what you sign. Generally speaking, the factor fee is three percent plus another fee per week the invoice is outstanding
  • Speed. With the right approach and relationship, you can receive the funds in as little as one business day

Is Factoring the Same as a Traditional Loan?

On the surface, before you complete detailed research, you may believe that invoice factoring and traditional loans can be easily compared. While both allow you to obtain money, there are some key differences between the two:

  • There are three parties involved with factoring: your company, the factoring company, and the factoring client. With a traditional loan, you and the lender are the only parties involved
  • Factoring is a faster way to gain access to funds
  • Unlike traditional loans, the paperwork associated with invoice factoring is less extensive and time consuming
  • The amount of capital you can access depends on the amount of the outstanding invoices. This can increase over time
  • Factoring is much easier to qualify for than a traditional loan

This does not mean invoice factoring is always the better of the two options. Factoring is generally option for those who can’t qualify for a traditional bank or SBA loan.

Types of Businesses that Benefit from Factoring

If you have outstanding invoices, there is a chance that factoring could be the answer you have been searching for.

However, factoring is only an option for some businesses. It is best if you:

  • Have business to business sales
  • Are offering payment terms between 30 and 120 days
  • Work on a “final sale” basis. Factoring companies do not work with companies that sell products on a contingent or consignment basis

While not the best choice for every company, any business that invoices in a B2B environment can qualify for invoice factoring. The only stipulation is that the company has outstanding invoices that can be sold.

Note: the amount you qualify for is based on the quality of your invoices, such as the terms, as well as the total amount and your credit worthiness.  

Even though any company with a B2B business model can take advantage of invoice factoring, some of the industries that rely on this heavily include:

  •  Trucking and transportation companies
  •  Staffing companies
  •  Manufacturing companies
  •  Distribution companies
  •  Oil companies
  •  Gas companies
  •  Commercial landscaping companies
  •  Janitorial companies

If your company operates within one of these industries, you may be in good position to benefit from invoice factoring.

Tip: when speaking with factoring companies, explain your business model and ask if they have experience dealing with businesses in your industry.

Why Rely on Factoring?

With so many other ways to increase cash flow and grow a business, it is hard for many small business owners to wrap their hands around the idea of invoice factoring. This is particularly true among those who don’t have any experience in this area.

Before you make your first move, compare the pros and cons of factoring against other methods of financing, such as lines of credit, short-term loans, and business credit cards.

The main reason companies turn to invoice factoring is to avoid lumpy cash flow. But, there are definitely other reasons a small business owner would turn to factoring. For example:

  •  Ability to obtain better supplier terms, such as a discount for paying in advance with cash
  •  Purchase equipment
  •  Purchase inventory
  •  Meet payroll
  •  Pay rent or other building-related costs

The reason why one company relies on invoice factoring may not be the same as the next. As long as you are comfortable with what it provides, it is something for your business to consider.

Advantages of Factoring

Before you decide in favor of invoice factoring, as opposed to other forms of financing, you should understand the many advantages. This will help you decide if this strategy is best for your business at the present time.

While every business will make its own list of factoring pros and cons, most soon realize there are four primary advantages:

  1. Fast access to cash. When you need money in a hurry, there are a few options to consider. Factoring is one of them. Depending on your situation and whether you have an established relationship with a factoring company, you may be able to obtain funds within one business day. When compared to other options, such as a small business loan, you realize that invoice factoring is much more time efficient. With a loan, it is not uncommon to wait several weeks to receive an approval. Worse yet, you may be denied for the loan, which means you spent many weeks waiting around, just to find that you are back at square one. If time is of the essence, if you need money fast, invoice factoring could be the best strategy for your business.
  2. Invoices serve as collateral. Like many companies, you may shy away from some types of financing because of the collateral that is required. You don’t want to “put up” anything against the loan, because it is at risk if you default.With factoring, this is not a concern since your invoice serves as the collateral. If something goes wrong, the factoring company can always collect on the invoice as a means of recovering losses. If you want to avoid putting up more conventional collateral, such as a piece of real estate, this may be the best idea.
  3. Outsourced collections is a possibility. This may or may not be something you are interested in, but for many companies it is a big advantage when compared to other financing options. As a small business, you may not have the internal manpower and/or time to handle all collections related activity. Of course, this doesn’t mean you can sit back and allow your customers to do what they want in terms of payment. You still want to collect as quickly as possible. When you opt to enter a relationship with a factoring company, they may be able to provide collections services as well. This allows you to focus on other parts of your business that are more important to your success.
  4. Good credit is not a must. There is no two ways about it: when you apply for a business loan, your credit is taken into consideration. If your business has good or excellent credit, you are in position to be approved. If not, you could be denied. With invoice factoring, this is not nearly as important. While your credit worthiness may come into play when calculating how much money you can receive, it is not the end all. All in all, the factoring company will focus primarily on the details surrounding your outstanding invoices. These companies don’t put as much stock in your credit rating as a traditional bank or financing institution would.

Disadvantages of Factoring

After reviewing the many advantages of invoice factoring, you may be wondering what has taken you so long to consider this idea.

Despite the benefits, despite the fact that many companies have used factoring to their advantage, you still have to consider the good and bad before making a final decision.

Here are some of the primary disadvantages associated with invoice factoring:

  1. Giving up a portion of your profits. When discussing factoring disadvantages, this is where you have to start. The idea behind this type of financing is simple: you receive instant cash for your accounts receivables in exchange for some of your profits. If you need to collect the entire amount of your invoice, if you are not willing to give up a portion of your profits, you should rethink the idea of using invoice factoring. On a $100,000 invoice, for example, you are mostly likely going to part with a minimum of around $4,000. You have to answer this question: is it is worth the $4,000 to access the other $96,000 without the wait? If so, factoring could be right for you. If not, you should opt for another form of financing.
  2. Higher fees than traditional financing. With factoring, you are able to get your hands on cash in a hurry, sometimes as quickly as one business day. While this is a definite benefit, you are going to pay in return for the service. Invoice factoring is typically more expensive than traditional financing, due in large part to the fees. In case you forgot what we discussed above, here is a brief passage to refresh your memory: “After subtracting the 3% processing fee ($3,000), the financing company would keep its factoring fee.” So, you’re looking at paying at least 4% for money lent for a such a short period of time. Are you willing to pay these fees in exchange for fast access to cash and the potential ability to avoid the collection process?
  3. Slow customers will impact how much you owe. As you know, some customers pay on time, every time. And then there are those who always lag behind, never adhering to the terms of the invoice. This can have a big impact on your bottom line if you are using a factoring company. Here is why: the longer your invoice is outstanding the higher your factoring fee will be. For instance, your fee may be 1 percent for each week the invoice is outstanding. With this in mind, a company that pays a $100,000 invoice after one week will result in a factoring fee of $1,000. However, if the company takes five weeks to pay, your fee will increase to $5,000. For this reason, you need to review how quickly your customers have paid in the past. This will help you decide if invoice factoring is the right decision. It will also help you decide which client invoices to sell. As a general rule of thumb, it makes more sense to sell invoices associated with customers that have a long history of paying quickly and in full.

Final Word

Factoring is a fast, simple, and effective way to get the cash you need to grow your business.

Now that you understand the finer details, how this financing compares to other types, and the pros and cons, you are in position to decide if this could improve your company’s financial situation in the future.


Meredith Wood

Meredith Wood

Editor-in-Chief at Fundera
Meredith is Editor-in-Chief at Fundera. Specializing in financial advice for small business owners, Meredith is a current and past contributor to Yahoo!, Amex OPEN Forum, Fox Business, SCORE, AllBusiness and more.
Meredith Wood
  • Jason Krasick

    We’re in the wholesale and distribution business and sometimes face cash flow issues with larger orders. Is there a preferred factor for my industry?