How Invoice Factoring Works

how invoice factoring works

Late-paying customers and vendors can disrupt your company’s cash flow and cause you unwanted stress. However, it is quite common for businesses to purchase goods and agree to pay for them 30 days, 60 days, or even 90 days later. As a result, you need to make sure that your company 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 end up with 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 that you have readily available to manage your short-term obligations, and a lack of liquidity could put your company at risk of default. If you have a stack of unpaid invoices and need cash right away, there are several short-term financing options 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. It is a scenario in which a small business sells its unpaid invoices to a financing company that specializes in invoice factoring. In return, the factoring company provides a lump sum of cash that is usually between 70% and 90% of the total amount of outstanding invoices. When customers and vendors pay their invoices in the future, the factoring company collects them and provides the balance to the small business. Factoring companies charge a factoring fee on the amount borrowed, and this is deducted from the balance.

Real-world scenario.

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 that caters to well-known bands, singers, and music industry producers. One month, she produced several recordings for her clients that generated $25,000 in revenue. Her clients agreed to pay their invoices 30 days after the recordings were completed, but Nicol needed cash to cover the cost of office rent, electricity, craft services, and to pay her studio engineers. 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. Obviously, things like credit score, time in business, and annual revenue are the first things that 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 fairly 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 a financial dire straits, particularly in the event that your factoring company asks you to buy back the unpaid invoices down the road. Next, your company’s accounting department will no longer deal with your customers directly when it comes to collecting payments and maintaining good customer relationships. That is because most factoring companies prefer to collect payments directly. 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 what invoice factoring is, and how it works. Our company does not offer this product, but we have some fast, easy alternatives that are perfect if you are in a cash crunch. These include short-term business loans and unsecured business loans.