If your business needs a quick source of capital to overcome a cash flow gap or struggles with slow-paying customers, invoice factoring can be an effective solution.
Like all forms of financing, there are benefits and drawbacks to factoring that make this type of funding more suited to some businesses than others.
Let’s take a closer look at how factoring works and review the pros and cons so you can determine whether this type of funding is right for your business.
What is Invoice Factoring?
Instead of loading long-term debt onto your business like a traditional loan, invoice factoring allows you to quickly access the money owed to your business by your customers. You can turn your outstanding invoices into a source of fast funding.
In an invoice factoring agreement, a business can sell its accounts receivable at a discounted rate to a third party known as a factor. Rather than waiting 30+ days for your customers to pay, you submit your outstanding invoices to the factoring company and receive up to 95% of the invoice value upfront.
You can use the cash payment immediately as your daily working capital. A factoring agreement can be beneficial if you need a prompt cash injection rather than waiting out the invoicing terms to receive payment.
The factoring company will collect payment from your customer when the invoice is due and transfer the remaining balance of the invoice less fees.
The Pros and Cons of Invoice Factoring
It’s important to consider both the positives and negatives before agreeing to an invoice factoring arrangement. This type of funding facility offers several benefits, but also some drawbacks that make it unsuitable for some businesses.
Pro – Quick Cash Flow Boost
Invoice factoring gives you immediate access to money owed to your business. It means that you can keep your business running, pay suppliers, and take on new orders with sufficient cash flow.
While a traditional bank loan can take up to several months to be approved and is subject to strict lending criteria, invoice factoring can provide a cash advance in as little as 24 hours.
Pro – Predictable Working Capital
You can take on new clients and make plans to expand, knowing that you have enough working capital to support your business decisions. An invoice factoring facility means that as long as you keep making sales and raising invoices, cash flow gaps will never be a problem.
Pro – High Approval Rate
Unlike a traditional business loan, the length of your trading history and credit rating does not play a significant role in the approval process. The factoring company is more concerned with your customers’ payment history and creditworthiness. If you struggle with a low credit score or have previously been rejected for a business loan, you may still qualify for invoice factoring.
Pro – Save Time and Money Spent Chasing Payment
Chasing outstanding invoices is a time-consuming and expensive task. Australian SMEs spend an average of 12 business days a year chasing payment from customers.
By outsourcing your account management and collections, you will have more time to focus on increasing sales and growing your business.
Pro – No Property Security Required
Your outstanding invoices act as collateral in an invoice factoring arrangement. There’s no need to use your family home or property as security like a traditional business loan or credit card.
Con – Cost
You will need to consider if the fees associated with factoring work for your business. If you can generate more revenue and profit with a faster cash turnaround, invoice factoring can speed up your business’s growth.
If your company trades on slim profit margins, it might make more sense to wait until you receive the full invoice amount.
Con – Limited to the Value of Your Invoices
A debt factoring facility is limited to the value of your outstanding invoices. While this is generally enough to support working capital, you may need a different business finance solution if you need funding for a large business purchase.
Con – Dependent on Creditworthiness of Your Customers
The invoice factoring company will consider your customer’s payment history to calculate the risk of purchasing your invoices. If you have a customer with a poor credit rating and history of late payments, it’s unlikely that the finance company will accept those sales invoices for factoring.
Con – Your Customers Will Be Aware of the Factoring Arrangement
With invoice factoring, your customers will generally be aware of your relationship with the finance company. If you prefer to keeping your funding arrangement confidential, an invoice discounting facility may be more appropriate.
What is the Difference between Invoice Discounting and Factoring?
Invoice finance is an umbrella term that describes the various ways a business can secure funding against unpaid invoices. The most common types of invoice finance are factoring and discounting.
These funding solutions allow a business to use it’s outstanding invoices as collateral to secure a fast cash injection.
With invoice discounting, you bill your customer as usual, submit the invoice to the finance company, and receive an advance of up to 85% of the invoice value upfront. When the customer pays the invoice, you receive the remaining balance less fees.
There are some significant differences between discounting and factoring.
In an invoice discounting arrangement, you remain responsible for the collection of the outstanding invoice. If you have a dedicated accounts and collections department, this can be beneficial. Due to the collections and account management services associated with factoring, it usually costs more than invoice discounting.
Another key difference is confidentiality. An invoice discounting facility is usually a confidential funding arrangement between you and the finance company. Your customers will be unaware that you are using your sales invoices to access funding.
Is Invoice Factoring Right for Your Business?
According to the Australian Securities & Investments Commission’s latest report, 51% of insolvencies are due to inadequate cash flow. If your business needs funding, invoice factoring can be a fast way to ease cash flow gaps and help you better manage your working capital.
Below are some of the top reasons why businesses use factoring services:
- Business is seasonal, and there are peaks and troughs in your invoicing cycles that result in cash flow variations.
- You are a rapidly growing company that needs working capital to purchase supplies and inventory.
- You issue numerous invoices each month and offer your customers payment terms.
- You are building your credit rating.
- You need financing but don’t have high-value assets to use as collateral for a loan.
Ultimately, factoring rates and fees will result in having less money paid into your business for your existing invoices. But if speeding up cash cycles will enable you to fund orders and take on new customers, invoice factoring can increase your revenue and improve profitability.
If you want to see how invoice finance can help a real business grow, check out ourcase studyon Victoria base confectionery company Bramble & Hedge.
Invoice factoring is a lasting solution that ensures that enough cash is paid into the business to sustain growth. If you need a large amount of capital for a significant business purchase, you may find asset finance is more suited to your needs.
ScotPac Debt Factoring
>We believe every business deserves the chance to grow. Our team of business funding experts and local decision-makers strive to help our customers get the capital they need, whether through invoice factoring, discounting, or another business finance solution.
>If you need some help deciding whether invoice factoring is right for you, speak to one of our friendly financial advisors today, and we’ll guide you through your options so you can make the best choice for your business.