Invoice factoring is a practice that is used by companies and involves selling their invoices to a third party. This method is widely used and results in an instant boost in cash flow, which can certainly come in handy from time to time. Only commercial invoices are factored, think of it as a payday loan for businesses with a much better interest rate.
Invoice Factoring Definition
The company sells its accounts receivable invoices to the third party which is called a factor at a discounted amount, which is where the practice gets its name – “invoice factoring”.
Advance factoring is commonly used in this process and involves the third party providing up-front cash in the form of a cash advance to the company. This cash advance can be anywhere from 70-85% of the actual purchase price. The company will receive the final amount once those accounts have been collected in full. The factoring company will generally keep 1-6% depending on how quickly they get paid. Usually about .001 per day. So if the company pays in 30 days x .001 the factoring company keeps .03 or 3%
How Does Invoice Factoring Work?
Here is and example of Transportation Invoice Factoring
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It’s important to understand that invoice factoring is in no way a loan of any sort, it is literally selling your receivables at a discount. What the most important thing to the factor is the actual credit-worthiness of the debtor’s. They are not interested in the cash flow, assets, and credit history of they company they are factoring for as it’s the debtors they will be collecting money from. Other than any possible judgements, leans or tax debts, its all on the credit worthiness of the company that owes the receivables to the company being factored.
The process involves three different parties which are the debtor (which is the customer that still owes money on the account), the company/person who has sold the receivable, and the factor.
When these accounts are sold there is a transfer of ownership from the receivable to the factor. This means after the deal closes the factor then owns all the rights to the receivable. The debtor is usually told about the sale to the factor so they can expect to deal with the factor for debt collection. The factor will bill the debtor as well as send a notice of assignment then follow up on the collections.
It’s also important to note that invoice factoring is a different process than invoice discounting. Invoice discounting means the borrowing of money and the receivables are used as collateral in this loan.
Who Uses Invoice Factoring?
This commonly used practice is seen throughout the business world. Companies that are in the process of recovering, growing, and even entrepreneurs often look at it as a good solution. A company doesn’t have to be in bad shape financially in order to use invoice factoring. In fact, many of the largest companies throughout Europe and North America have used the practice at some point. Most commonly the practice is used by new, small, and medium sized businesses.
Once the receivables have been sold to the factor the injection of cash into the business is instant and can be used to:
• increase the amount of employees
• increase sales
• buy new equipment/machinery
• fund payroll
• open new branches or renovate current ones
• increase inventory
• offer supplier discounts to build your customer base
• increase marketing efforts
• enhance the company’s credit rating
Why Choose Invoice Factoring?
If a company is looking for an injection of cash why not just get a bank loan? Well there are a number of advantages in taking the route of invoice factoring instead. Some of these include:
• There is no need to go through the credit approval process. With invoice factoring it’s all about the customer’s credit-worthiness not the company’s. As long as that customer seems as though they can pay their account, then it’s a good investment from the factor’s point of view.
• The amount of cash the company will get from the factor is dependent on the amount outstanding by the debtors rather than the company’s assets and what the company will qualify for.
• Unlike a loan there is no increase in the company’s debt load. By taking out a loan it will be seen as a debt against the company, which doesn’t help the company’s financial position.
• With loans there are often restrictions and rules on what the cash can and can’t be used for. With invoice factoring the money can be used any way the company wants and there is no need for a bank audit.
• If the company is in need of some help when it comes to its credit rating, this method can increase the rating by giving them cash flow to pay their bills.
• There is no need for the company to spend time and energy on collecting from accounts receivables instead it is the factor’s responsibility. This means the accounts receivable department doesn’t have to be huge with multiple employees working on collecting outstanding invoices.
• The cash flow in a company can often fluctuate going through good times and then not so good times. Invoice factoring is a quick way to get the company through the slow time by providing instant cash. It helps a company stay at a stable and consistent level.
Where Did Invoice Factoring Stem From?
This practice has been used for a number of years. It’s said that it dates back to the Mesopotamian culture that had the rules of factoring in Hammurabi’s Code of Laws. It was then seen in England possibly before the year 1400. It wasn’t practiced in America until the pilgrims arrived sometime around 1620. In other words, this is a practice that has quite the history.
Granted the process evolved over the years, as does everything. As businesses grew, technology bloomed, communications flourished, telephones emerged, and then computers the practice had to chance in order to keep up.
In fact by the 20th century invoice factoring was the most popular and widely used form of securing working capital for the textile industries in the United States. Canada followed suit and the textile industry was soon relying on invoice factoring there as well. It was so much easier to gain working capital using that method rather than going through a bank. At that time there were a number of small banks and there were a lot of restrictions on just how much money a company could borrow and what they could use it for. They just couldn’t keep up with the textile industry’s booming marketplace.
The Current Face of Invoice Factoring
As mentioned invoice factoring has definitely evolved and changed over the years with today’s looking very different. When a factor is brought into the fold it usually provides a number of key services which are:
• The factor will gather and provide information regarding the credit-worthiness of the debtors. If nonrecourse factoring is being used the factor will also take on the credit risk for any approved accounts.
• The factor provides a history of all collections received by means of an accounts receivable ledger.
Thanks to the advancements in technology even the way the factor communicates with debtors has changed. Nowadays they can chat with debtors in real-time regarding their invoice. There is no need to wait to have signed originals sent back and forth in the mail because the law recognizes signed faxes as being legally binding.
So What Are The Risks?
While there seems to be plenty of advantages and pros for invoice factoring it’s also important to understand the risks involved.
First off there is always the risk of external fraud by the client/company. This is a risk the factor takes understanding that there may be pre-invoicing, misdirected payments, credit notes that weren’t assigned, and even fake invoices.
• Arguments about the contract can occur as there is sometimes a UCC filing by the factor.
• There may be a lien by the IRS with payroll taxes that could keep you from getting factored.
• There could be tax risks, compliance issues, and legal problems if you’re dealing with customers in different countries. So not all industries can factor but most companies with commercial clients can.
• The credit-worthiness of the debtor is always a risk.
• Depending on the debtors the fee the factor company charges can end up being quite high. If the debtors doesn’t have a good payment history or desirable credit-worthiness the factor company will see them as high risk and therefore charge the company a much higher factoring fee or not buy those receivables at all.
• It’s important to discuss what will happen should the debtor not pay its invoice. Who is then responsible for that account? In recourse factoring the receivables will be charged back to the company.
• For some companies they don’t like the idea of selling their accounts receivables because it feels as though they are giving up control of its sales ledger.
• If the company doesn’t do its research on the factor company being used they could be in for hidden fees as some are more likely to use this tactic than others.
• Sometimes the repayment isn’t what the company is expecting so it’s important this be very clear from the start so there are no surprises.
Starting the Process
In order to get a good idea of whether or not this is the right route for a business it’s important to draw up financial projections of the company looking at two scenarios – one without invoice factoring and the other with invoice factoring. Once the numbers are on paper it will make the decision process a whole lot easier. Companies can often be surprised at the results and findings.
Look at how invoice factoring will impact not just the company’s cash flow but also its losses, profit, and debt. The next step is to take a good look at what the cash flow would be used for? How will it benefit the company in the long-run? Will this extra cash flow somehow impact your profits either in the short-term or long-term?
If invoice factoring seems to be the best course of action then the process starts with the company making a list of all the invoices that are outstanding. This is the list that will eventually be handed over to the factor so making sure all the information is complete, correct, and has the proper signatures is imperative. The company may not wish to turn all its accounts receivables over, maybe they just want to sell a portion of them, some factors are ok with this, some are not.
When the list is ready it’s time to choose a factor. This can be done through a number of different companies/services offering such financial services. The factoring company will then take a look at your list and check the debtors for their credit-worthiness and payment history. It’s up to the factor company to then decide if it wants to accept and purchase your invoices. During this process the factor company will look at each of the debtors’ invoices looking for any missing details, errors, discrepancies and more.
Next comes the terms of the agreement. This is when the up-front cash amount will be discussed and decided upon. The factor will also divulge its discount rate, which is essentially its fee for performing all the collections.
After the factor has taken over these accounts it will send out a letter to all of the debtors to let them know where, how, and when to pay their balance since it will now be paid to the factor rather than the original company.
So how long does it take to get that cash up front? The factor will provide the up-front cash payment within two to five business days after the validation of all the debtors’ invoices. Some factor companies even promise money within 24 hours which is great for companies in desperate need of a quick cash injection.
Cash flow is something that is always a top priority in any business whether it’s big or small. Because business fluctuates, customers come and go, and the economy is always changing it’s not always possible to know where the company will stand from year to year. Invoice factoring can be a quick and simple solution for many businesses in need of a quick cash flow injection.
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