It’s no secret that cash flow is the lifeblood of business. And as such, you may well be in a position where your P&L and top-line revenues appear healthy, but your cash flow is suffering, with late invoice payments from your customers proving consistently to be the main culprit.
Indeed, with payment terms potentially stretching out as far as 120 days in some instances, those late payments could prove critical in determining whether or not you can make payroll and pay your bills, as well as complete important expenses and investments to grow your business. You might even be left in the precarious position of having to sell off some of your assets to ease this liquidity crunch.
Sounds familiar? If so, you are probably wondering whether there is a way to bridge that painful gap between revenues and actual cash flows. Thankfully, invoice factoring and invoice financing are two powerful financing tools that quickly deliver you cash from unpaid invoices. By improving your cash flow, therefore, these solutions can not only alleviate much of the damage inflicted by long payment delays, they also allow you to focus on the things that really matter, such as scaling and growing your business.
Key “At-A-Glance” Similarities Between Invoice Factoring and Invoice Financing
- Both offer ways for you to quickly raise cash from unpaid invoices. This cash can be crucial for expanding your business, investing in new technologies and seizing strategic opportunities that would have otherwise been unavailable.
- Both solutions are popular among small businesses that must deal with irregular cash flows and/or insufficient cash reserves. With customers invariably having anything from 30 days to 120 days to fulfill their payment obligations, the need to maintain solid cash positions during this time can be crucial.
- With more flexible terms typically offered under invoice factoring and invoice financing, both funding solutions can be preferable alternatives for businesses that do not meet eligibility thresholds for traditional bank loans.
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INVOICE FACTORING
What is Invoice Factoring?
Also known as “accounts receivable factoring”, invoice factoring involves selling your outstanding eligible invoices to another company – known as a factoring company - in exchange for an up-front cash payment (less a service fee).
With factoring companies often paying you up to 90% of the outstanding invoice value, invoice factoring enables you to quickly gain access to funds. And rather than paying you, those customers responsible for paying their outstanding invoice amounts will pay the factoring company instead.
How Does Invoice Factoring Work?
In terms of the actual invoice factoring process, once you have created the relevant customer invoices, you can begin applying to your chosen factoring firm.
The factoring company will screen your application, and based on such factors as your customers’ risk profile and your industry, will propose terms for providing the funding (including the service fee and percentage of the total invoice amount you will receive, usually 80-90%).
Once terms are agreed, you can promptly sell your invoices to the factoring company, which in turn will pay you the funds, typically within 2 or 3 business days. The company may also notify your customers regarding the invoice factoring arrangement in place, and manage collection of payment as it sees fit.
Example: Let’s assume you are about to issue an invoice that requires your customer to pay $15,000 with a 30 day payment term. But you have also decided to use invoice factoring to receive an up-front cash injection.
Before issuing this $15,000 invoice to your customer, you instead sell it to a factoring company which pays you an up-front lump sum of $13,500 – or 90 percent of the invoice total. The customer must now pay the $15,000 owed to the factoring company (instead of paying you) within the 30 days, as per the original payment terms, and does so on the 28th day.
For this service, the factoring company charges you a fee of 8% of the total ($1,200) – or 2% for every week that it takes the customer to make the payment - and returns the remaining balance ($1,500 - $1,200) of $300 to you.
So, while you received only $13,800 in total ($15,000 - $1,200), the opportunity to receive almost the full amount in exchange for a much improved cash flow through factor invoicing means that you are no longer exposed to the customer’s delayed payment schedule.
Who is Invoice Factoring Suitable for?
- If your business has a poor credit history, and/or is struggling to obtain financing through more traditional channels, invoice factoring could be the best fit. And since you do not need to post collateral, invoice factoring can be pivotal, especially if you do not meet the eligibility requirements for a bank loan.
- If your business faces consistently long gaps between revenues and actual cash flow. Such businesses are often found in industries such as trucking and transportation, oil and gas, food and beverage and wholesale and distribution.
- If your business sells goods and services to other businesses (B2B) rather than directly to consumers (B2C). Because invoices are usually issued within the B2B realm, invoice factoring becomes an appropriate funding method.
- If your customers are deemed as low credit risk, you are more likely to gain favorable terms in an invoice factoring arrangement. Having purchased the invoice(s), factoring companies are thus more concerned with the ability of your customers to fulfill payments, rather than the creditworthiness of your own business.
Pros of Invoice Factoring
- It is both a quick and accessible form of business funding. Gaining access to working capital can take as little as 24 hours. This speed can be vital in helping you to exploit significantly more growth opportunities.
- Invoice factoring is not a loan. While banks and other lenders will invariably require you to have a strong credit rating, factoring companies tend to have more relaxed eligibility criteria. If your business is in the very early stages of growth, this flexibility in gaining capital can be critical for stimulating growth.
- As invoice factoring is not a loan, you don’t have to worry about posting collateral. This also means that your assets are not in danger of being seized should your customers fail to pay the factoring company.
Cons of Invoice Factoring
- Should your customer make a late payment, the factoring company’s service fee can accumulate substantially. And should the arrangement involve several tardy customers, invoice factoring could end up being painfully expensive. If your customers have track records of making late payments, it may be preferable to simply wait for their payments instead of entering into an invoice factoring agreement.
- Does your agreement come with “recourse financing”? If so, then you are liable for any invoices that remain unpaid by the customers (not the factoring company). Non-recourse financing facilities are available, but they are more expensive.
- Given that the ownership of unpaid invoices is transferred to the factoring company, invoice factoring can significantly erode the relationship you have with your customers. It is the factoring company, rather than yourself, that now manages the collection of money from your customer. And should the factoring company manage this aspect in an aggressive or unconventional manner, the resultant damage to your business could be irreparable.
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INVOICE FINANCING
Also known as accounts receivable financing or invoice discounting, invoice financing allows you to receive cash in the form of a loan or line of credit from a lender or discounting company against your outstanding invoices.
Unlike invoice factoring, therefore, invoice financing is a short-term borrowing facility with the amount due on your invoice(s) becoming collateral within the loan agreement. It is like a conventional loan in that regard, such that you agree payment terms, the interest rate and collateral terms with the lender.
Once your customer pays the invoice, you then repay the loan amount to the lender along with the service fee and interest rate, normally represented as a flat percentage charge.
So, while invoice factoring enables you to obtain funds through a factoring company purchasing your outstanding invoices, invoice financing provides you with the funds through a lending company which provides you with a loan.
How Does Invoice Financing Work?
Let us use a similar example to invoice factoring above to illustrate how invoice financing works.
In this case, you have an invoice for $50,000, again with a 30-day term limit. You borrow 90% of the outstanding total from the lending company - $45,000 – and are charged 2.5% ($1,250) for every week that the customer does not make the payment.
Should the customer pay the outstanding $50,000 to you after 3 weeks, the amount in fees that you owe the lender will be $3,750. As such, you will return to the lender a total of $48,750 (the principal $45,000 borrowed PLUS the $3,750 in fees), and keep $1,250.
To apply for invoice financing, you will most likely need to provide the lender with key information about your business, including previous financial statements, bank statements, the invoices you would like to finance, and credit ratings for both your relevant customers and your business.
Who is Invoice Financing Suitable for?
- As is the case with invoice factoring, if you are wishing to generate cash flow from unpaid invoices invoice financing can be an appealing solution. And that also means invoice financing will suit B2B businesses.
- Is maintaining control over your customer relationships particularly important to you? Given that you remain in charge of invoices and are responsible for collecting payments, invoice financing may be preferable to invoice factoring.
- If you are unable to access traditional funding facilities, but nonetheless have a solid credit score, invoice financing can be the most suitable option
- Businesses with a strong trading history in which invoices have been regularly issued in the past. The lending company will then examine your previous financial statements, your customers and the reliability of their payments.
Pros of Invoice Financing
- Although you are still applying for a loan under invoice financing, the lending terms still tend to be more favorable than a typical bank loan. This can be a lifesaver for many businesses that remain shut out from the traditional banking system.
- With invoices operating as collateral in invoice financing agreements, it is typically much easier for you to qualify for these types of loans. Should your customers have demonstrably solid payment histories, moreover, invoice financing may end up being the most accessible solution, even if your credit history is far from ideal.
Cons of Invoice Financing
- As is the case with invoice factoring, the fees for invoice financing can be expensive, particularly if the client does not pay you quickly, and you therefore must wait to repay the lender. The longer the delay, the higher the fees you will accumulate.
- Again, you might be at risk should your invoice financing agreement involve recourse financing. Should your customers fail to pay their invoices, you remain liable for repaying your lender. The invoice will also remain on your balance sheet as an account receivable in such a scenario.
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What are the main differences between Invoice Factoring and Invoice Financing?
Financing Type: Perhaps the most glaring difference is that invoice factoring is not a loan, whereas invoice financing requires that you borrow from a lending company. As such, you will be adding debt to your balance sheet by opting for invoice financing.
The Parties Involved: With invoice factoring, the customer is involved in the funding arrangement and is required to make payment to the factoring company. With invoice financing, however, the customer is not involved and continues to make payment to you as per the original payment terms. So, who the customer pays differs in each case.
Obligations: While invoice factoring offloads the management of your outstanding trade receivables (invoices) to the third-party factoring company, invoice financing requires that you be responsible for collecting payment from customers.
Creditworthiness: Given that factoring companies depend on receiving payment from the customer, it is the customer’s credit history that is of prime importance in invoice factoring. And although invoice financing arrangements depend on the customer’s ability to pay you, it is ultimately your credit history that lending companies will scrutinize and charge accordingly.
Cost: Although similar in nature, invoice factoring tends to be more expensive than invoice financing. This is largely because the cost of managing the customer relationship with respect to unpaid invoices for the factoring company in invoice factoring is not an equivalent consideration for the lender in invoice financing.
In both cases, however, much ultimately depends on when the customer will pay the invoice. As such, the amount you end up paying to either the factoring company (invoice factoring) or the lender (invoice financing) is not entirely in your hands. And should the customer end up missing the payment or making a very late payment, you will almost certainly incur additional fees.
