When a business owner runs into difficulty with finances, they may look at different options to raise capital. One potential option that often comes up is invoice factoring. But what is invoice factoring for small businesses and how could it work for you?
In this article, we are going to discuss the ins and outs of invoice factoring for small businesses, including how this method of finance works and the pros and cons of invoice factoring.
Raising finance for your small business through invoice factoring
If your business is growing rapidly and has plenty of trade coming in, you might expect that your finances would be healthy. However, this is not always the case.
When a business expands rapidly, you may be selling so much that you just can’t receive payments quickly enough to purchase your next batch of raw materials to create your new stock. This is a common problem for businesses that issue invoices on 30-day or even 60-day terms.
As the business continues to grow, you will find that more and more of your money ends up being tied up as working capital. This can lead to real cash flow problems for your business.
Invoice factoring provides a unique solution to this problem, but how exactly does it work and is it right for your business? Read on to learn everything you need to know about invoice factoring for small businesses.
What is invoice factoring?
Invoice factoring is a type of invoice finance, allowing a business to raise capital through their outstanding invoices. This type of finance involves selling your company’s outstanding invoices to a third-party company to improve your cash flow and generate capital.
The invoice factoring company will pay you a large percentage of the invoiced amount immediately, and then collect the payment directly from your customers. Once payment has been collected, they will then take their fee from the profits before handing over the remainder of the invoice balance to you.
There are a few things that you need to be aware of before you decide to use invoice factoring to free up capital for your business. You will need to know the pros and cons of invoice factoring, as well as understanding exactly how this type of invoice financing works.
How does invoice factoring work?
When you use invoice factoring to free up capital for your business, you will be selling control of your accounts receivable. This means the invoices that you have sent out but not yet received payment for. You can choose to sell control of your invoices in full or in part.
Here is the process of invoice factoring:
Provide goods or services to your customers in the normal way.
Invoice your customers for the goods or services provided.
You then sell the raised invoices to a third-party invoice factoring company. The factoring company will verify that the invoices are valid and then pay you large percentage of the invoiced amount, typically around 70-85% of the total value.
Your customers will pay the invoice factoring company directly. The third-party company will chase payment of the invoice if required.
You’ll then be paid the remaining percentage of the invoice by the invoice factoring company, minus their fee.
Pros and cons of invoice factoring
There are many benefits of invoice factoring, but also several disadvantages that you should be aware of. You will need to carefully weigh up these factors before deciding whether invoice factoring is right for your small business.
The pros and cons of invoice factoring include:
Improved cash flow
May impact customer relationships
Increased chances of business survival
Unsuitable for businesses with a small customer base
Cheaper and easier than bank loans
Increased costs for risky customers
Reduced business overheads
Extra costs when it doesn’t work out
Advantages of invoice factoring
Invoice factoring is a popular method of business financing for small businesses, thanks to its many benefits. Here are some of the advantages of invoice factoring.
1. Improved cash flow
Utilising invoice factoring enables businesses to free up capital by having the majority of their invoices paid almost immediately. This means that small businesses don’t have to wait for the 30-day payment term to receive their hard-earned cash.
This improved cash flow helps to facilitate accurate business planning and forecasting, as well as enabling business owners to take advantage of opportunities that might otherwise be unaffordable.
2. Increased chances of business survival
The world of business is tough, leading many businesses to fail in their infancy. Improving your cash flow through invoice factoring can dramatically increase your business’ chances of survival in this challenging financial climate.
3. Cheaper and easier than bank loans
Bank loans have high interest rates, along with strict criteria. Invoice factoring is typically a cheaper option for businesses, as well as being easier to obtain than a business loan. This makes invoice factoring a tempting option for short-term business funding.
4. Reduced business overheads
Chasing payments is often stressful, as well as being costly. Utilising invoice factoring services can help to reduce your business overheads by removing the need to chase unpaid invoices. Although there are fees associated with invoice factoring, these are often lower than paying dedicated credit control staff to chase late invoices.
Disadvantages of invoice factoring
Whilst there are many benefits of invoice factoring, there are also several disadvantages to this method of finance that you will need to be aware of before making an informed decision. Here are some of the disadvantages of invoice factoring.
1. May impact customer relationships
Invoice factoring may have a negative impact on your customer relationships. This is because you are handing over control for your invoices to the invoice factoring company, meaning that they will be dealing with your customers directly.
If the invoice factoring company is harsh or aggressive when pursuing the debt, your customers are likely to hold this against your company, reducing their likelihood of working with you in the future. Additionally, customers may have reduced trust in a company which uses an invoice factoring company, seeing it as a sign that your business is not performing well.
2. Unsuitable for businesses with a small customer base
Many invoice factoring companies will only work with companies which have a large customer base. This is because invoice factoring companies prefer to spread their risk as widely as possible, so tend to avoid a high concentration of invoices to a small number of customers. This means that invoice factoring is not suitable for companies which have a small number of clients.
3. Increased costs for risky customers
When you decide to sell your invoices to an invoice factoring company, they will analyse the invoices to determine the level of risk before deciding on a fee. The fee will take into account the risk of late payment or non-payment if they take on your invoices. If your business or the businesses of your customers are deemed to be high risk, the fees that you will incur will be higher as a result.
4. Extra costs when it doesn’t work out
Some invoice factoring companies will charge additional fees if your clients pay their invoice late. Additionally, if a customer fails to pay the invoice, you may have to repay the money that was paid to you by the factoring company, unless you paid extra for non-recourse factoring.
Who can use invoice factoring?
Many small businesses choose to use invoice factoring to raise capital for their business, but not every small business will be eligible. The eligibility criteria will vary between invoice factoring companies, but the criteria will usually include the following:
Your business is registered in the United Kingdom
The business owner is over the age of 18
A minimum volume of invoices (the number will vary between lenders)
Customers have a solid credit record and payment history