It isn’t easy to build a balanced cash flow for your business, but it is important. Without a reliable flow of cash, you could easily find yourself without the ability to pay your employees, your vendors, or your utility bills, essentially stifling your business for an unknown amount of time. That’s why so many businesses engage in practices that help regulate their cash flows ― including invoice factoring.
Invoice factoring is a process that allows companies that provide B2B services or claim government contracts to sell their unpaid invoices to a third party, an invoice factoring company. Unlike accounts receivable financing or invoice discounting, factoring is a straight-up sale ― which means the money you receive is yours to use however you like, and you never have to pay the factoring company back. Whether your business is seasonal or you want to receive your payments faster, factoring is a viable option.
Still, as with every finance trick, there are secrets to doing it right. Here are a few tips to help you make the most of your invoice factoring experience.
Know the Factoring Terminology
Factoring has a long history in western markets, which means factoring companies have enjoyed centuries in which to develop their own distinct jargon. For any hope of understanding your factoring contract, you need a firm grasp of factoring lingo. Here are a few of the most common terms:
- Account debtor: This is your client, or the person responsible for paying the invoice.
- Advance rate: This is the amount you will receive immediately for factoring your invoices. Most factoring companies will advance between 75 and 85 percent of your invoices’ deemed value.
- Reserve: This is a portion of the value of your invoices, represented by a percentage, retained by factoring companies to potentially pay for bad expenses, payment shortages, and other issues.
- Factors: This is another name for factoring companies.
- Factoring period: This is the time between when the factoring company purchases your invoices and when your customers pays the invoice in full. The period typically lasts between 30 days and 90 days.
- Invoice discounting: In some countries, discounting is the same practice as factoring. However, in the U.S., discounting is another name for accounts receivable financing, which is essentially a business loan using your accounts receivable as collateral ― distinctly not factoring.
Know Your Customers’ Payment Habits
Like other financing options, factoring relies on credit scores to determine how much cash you will receive; however, unlike loans and lines of credit, it isn’t your credit score that matters. Rather, your customers’ and clients’ creditworthiness influences your advance rate as well as potential interest rates that could deplete your reserve. Therefore, before you factor your invoices, you should consider your clients’ payment tendencies: Do they ever pay late? Do most or all have a habit of paying late? Do you know if your clients have poor credit? If your answers are unequivocally “yes,” you might wait to factor your invoices until your clients’ payment practices shape up.
Know the Rates, Fees, and Other Charges
Most major factoring companies have good reputations, but that doesn’t mean you should take it for granted. Sometimes, factoring companies offer rates that are too-good-to-be-true precisely because they are; such factors will often levy harsh fees and other surprise charges that bleed away your hard-earned cash. You should never shy away from asking tough financial questions, including:
- Are there any additional fees not expressly noted?
- Are there any conditions that will cause you to incur surprise charges?
- Is there a monthly minimum or maximum number of invoices you can factor?
- Does the company offer 24/7 online reporting for you to monitor your account?
Know What Your Business Needs
As with any funding option, there are different types of invoice factoring such as recourse or non-recourse, or even industry specific like freight factoring . Which type you choose will depend on the cash needs of your business. For example, if you have strong seasonal sales, you might need short-term factoring to keep your flow healthy during the down-time, whereas if you are working toward expansion, you might want a long-term contract to keep costs low. Further, you might consider participating in recourse factoring, which allows you to buy back delinquent invoices, lowering your potential fees, as opposed to non-recourse factoring, where the factor absorbs the risk of uncollected invoices ― but charges you extra for the potential disservice.
Factoring is an excellent business opportunity ― if you know the ins and outs of the practice. Now that you know the biggest secrets of effective factoring, you can safely factor your invoices and find business success without worrying how you’ll stay afloat in between client payments.