If you’re a small business owner frustrated by outstanding accounts receivables, you might have heard of invoice financing and invoice factoring as possible solutions to dealing with a slow cash flow. And while both invoice financing and invoice factoring could help smooth out cash flow issues, it’s important to know before evaluating these options that they aren’t the same thing.
Also known as invoice discounting, invoice financing refers to borrowing money against your outstanding accounts receivables. A lender gives you cash now, and once your client pays up, you then pay the lender back the amount loaned plus fees and interest. In this scenario, your business is still responsible for collecting outstanding money owed by your clients.
Invoice financing suits businesses that need money quickly and feel confident they can collect on the outstanding invoices owed to them by their customers.
Invoice factoring is a form of invoice financing—with a twist. The lender “buys” the accounts receivables you’re owed and takes over collecting from your clients. With invoice factoring, the lender will pay you a percentage of the total outstanding invoice amounts, then takes responsibility for collecting the full amount. Once they collect the full amount, they’ll advance you the difference, keeping an agreed-upon percentage for their service. Your clients will deal with the factor company or lender to make their payment in this scenario, not you.
Accounts receivable factoring might be suitable for businesses with outstanding accounts receivables in the 60 to 90 days or longer time frames, or for those who don’t want to recover outstanding receivables on their own. These businesses are willing to accept receiving substantially less money from the lender than they’re owed by their customers, but don’t have the time, skill, or desire to chase down the customers to collect the money owed. These businesses are also alright with someone other than themselves interfacing with their customers.
Whether you’re using invoice financing or invoice factoring, there are some benefits to this form of business finance—primarily that it can smooth out cash flow issues very quickly. Businesses can use invoice financing to pay staff and regular bills without having to wait for payment on outstanding invoices to arrive. It could also be used to pay suppliers what you owe them on time—an important part of maintaining or improving your credit.
Also, whether you’re using invoice factoring or invoice financing, it might be the only option available to you if you can’t get other forms of business credit. Since these lenders look more at your invoices and less at your business’s financial health and your credit, you might find this type of financing easier to secure than others.
A benefit to invoice factoring, in particular, is that it guarantees at least some of your outstanding accounts receivables and removes the headache of collections from the already busy life of a business owner. If your business deals with numerous late-paying customers and/or unpaid invoices, invoice factoring can be an option to ensure that you do get at least some of what’s owed to you, giving you the cash necessary to stay afloat.
Another thing to note with invoice factoring is the limited risk to your business of not collecting outstanding payments. Once the factoring company takes over responsibility for collecting the receivables and you have your cash in hand, they’re taking over the risk that your clients won’t pay. Unlike a credit line or business loan, where you have to make payments whether your clients pay you or not, invoice factoring removes that risk from your books.
While invoice financing might seem like a simple and fast way to deal with cash flow issues, it can be expensive, especially if your fees are dependent on when the customer pays you back. The cost usually includes a flat processing fee, often around 3%, and then a certain percent per week the invoice remains outstanding.
Additionally, as we mentioned above, if you choose the invoice factoring route and the lender deals with collecting the outstanding amounts from your customers, there’s no hiding the fact that you’ve entered into a factor agreement. This might be a signal to customers that your business is in trouble. And while you may no longer see much value in customers whose outstanding bills are in the 90-day-plus category, what about your other customers? Even a rumor of financial troubles might affect your small business’s reputation and scare off existing and future good customers.
Many small business owners feel frustrated by the difficulties of meeting current expenses, debt repayments, and other financial obligations. To these business owners, invoice financing or factoring might seem like the only choice.
But there are other less costly methods to improve cash flow, like using online accounting and payment systems to make it easier for clients to pay, or offering incentives (like discounts) to clients who pay early. It might be prudent to try these tactics first, and if cash flow still doesn’t improve, then consider invoice financing or factoring.