How Invoice Factoring Works

how invoice factoring works

Estimated reading time: 4 minutes

Late-paying customers and vendors can disrupt your small business’s cash flow and cause you unwanted stress. However, it is pretty standard for companies to purchase goods and agree to pay for them 30 days, 60 days, or even 90 days later. As a result, you must ensure that your business always has enough cash in the bank to meet your important financial obligations, like employee payroll and rent, while you wait for the funds to come in. If you cannot do this, you will have a cash shortfall.

Over time, a lack of incoming cash can affect the overall financial health of your business. It can increase your debt-to-equity ratio, reduce your operating efficiency, and lower your liquidity ratio. Liquidity is the amount of cash and assets you have readily available to manage your short-term obligations, and a lack of liquidity could put you at risk of default. If you have a stack of unpaid invoices and need cash right away, several short-term financing options are available. One of them is invoice factoring, which is explained in this Balboa Capital blog post.

All about invoice factoring.

Invoice factoring, also called accounts receivable factoring, is not a business loan in the traditional sense. Instead, it is a scenario where a small business sells its unpaid invoices to a financing company specializing in invoice factoring. In return, the factoring company provides a lump sum of cash between 70% and 90% of the total outstanding invoices.

When customers and vendors pay their invoices in the future, the factoring company collects them and provides the balance to the business. Factoring companies charge a factoring fee on the amount borrowed, which is deducted from the balance.

A real-world scenario of how invoice factoring works.

To help you better understand how invoice factoring works, we think it would be helpful to present you with a real-world scenario. Nicol owns a recording studio catering to well-known bands, singers, and music industry producers. She produced several recordings for her clients that generated $25,000 in revenue in one month.

Her clients agreed to pay their invoices 30 days after the recordings were completed. Still, Nicol needed cash to cover the cost of office rent, electricity, craft services, and to pay her studio engineers. So she sold her invoices to a factoring company for $20,000 (80% of the total value of her invoices). Nicol’s clients paid their bills on time, and the factoring company gave her the remaining 20%, minus a 5% factoring fee, processing fees, and an origination fee.

How to qualify.

Not all lenders offer invoice factoring, and those that do have different borrowing requirements. Things like credit score, time in business, and annual revenue are the first things factoring companies look at during the initial decision-making process.

In addition, they will check to see that applicants do not have any tax problems or legal issues. The application is relatively straightforward and typically asks for personal and business information, tax returns, corporation documents, and financial returns.

Things to keep in mind.

Although invoice factoring can help you get cash quickly, there are a few things to consider before moving forward. First, there is no guarantee that your customers will pay their bills or that your factoring company will collect your customers’ unpaid invoices. This could put you in dire financial straits, particularly if your factoring company asks you to buy back the unpaid invoices down the road. Next, your accounting department will no longer deal with your customers directly when collecting payments and maintaining good customer relationships.

That is because most factoring companies prefer to collect payments directly. However, if you are not comfortable relinquishing this responsibility to a third party, you should consider a different solution for your short-term financing needs. Balboa Capital hopes this blog post helps you understand invoice factoring and how it works. We do not offer this product, but we have some alternatives to consider if you are in a cash crunch. These include short-term business loans and unsecured business loans.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.