This might affect its cash flow status. As a result, small business owners may not have immediate cash to buy raw materials in bulk, pay salaries and take care of other maintenance costs. In these cases, invoice factoring is a good option for them. Keep reading to learn more about what is invoice factoring and how it can help small and medium businesses.
This is a process where a factoring company (also known as a factor) buys unpaid invoices from the business owners in return for an immediate advance to them. Usually, the factor pays about 75% to 90% of the total invoice amount to the businesses within 4 to 7 working days of receiving the outstanding invoices. This way, the businesses don’t have to wait for the full payment cycle to get their money. The immediate advance paid by the factor helps them conduct their routine business operations without any hassles.
Yes, a factor charges a small percentage of the total invoice amount as its processing fee. This fee is also known as the discount rate in some countries. Usually, the charges of a factor are around 1% to 5% of the total invoice amount. At the end of the payment cycle (30 or 60, or 90 days), the customers of the business owners pay the entire amount to the factor. The factor then pays the remaining amount to the businesses after deducting the advance already paid and its processing charges.
Given below is a step-by-step explanation of how invoice factoring is done. For ease of understanding, let us explain the process with an example:
a) A small business owner, A, sells his unpaid invoices worth ₹10,000 to a factoring company, X. A also informs his customers about selling the outstanding invoices to X.
b) X checks the invoices and runs a quick background check on A’s customers to understand their risk profile.
c) Within 4 to 7 business days, X pays an advance of 80% of the total outstanding invoice amount to X.
d) X and A get into an agreement to decide on X’s processing charges (mostly around 1% to 5%).
e) A receives Rs 8,000 (80% of Rs 10,000) immediately to run his business without any hassles. If he had not chosen a factor, he would have had to wait until the entire payment cycle of his invoices (say 60 days) to get the money from his customers.
f) After 60 days, A’s customers pay the full invoice amount of Rs 10,000 to X.
g) X has already paid an advance of Rs 8,000 to A. X will now deduct its processing charges (say 3%) from the invoice amount, which is Rs 300. It then pays the remaining R1,700 (Rs 10,000 - Rs 8,000 - Rs 300) to A at the end of the invoice payment cycle.
A factor helps small and medium businesses by buying their outstanding invoices and paying them in advance immediately. However, not all growing businesses are eligible for these services. A factor conducts a thorough background check on the clients of these businesses to understand their history of payment, reputation, profitability, and other factors. A business must satisfy the following conditions to be eligible to choose the services of a factor:
a) Submit all valid documents related to profitability, turnover accounts receivable reports, and other information as required by the factor.
b) Must have an impeccable business reputation with no history of customer complaints, legal problems and the like.
c) The payment cycle should be between 30 and 90 days, as the factor may not want to wait for more than 90 days to receive its payment from the customers.
d) Clients with a good credit history can easily opt for invoice factoring. A factor will agree to pay a big advance to a business only if it has clients that don’t default on their payments.
e) Businesses should send their invoices to their customers; a factor will buy only those outstanding invoices already issued.
The answer to this question lies in carefully analyzing the pros and cons of invoice factoring. Businesses should understand the terms of the factors fully well before getting into an agreement. Yes, getting immediate cash may seem like an easy and immediate solution, but it is also important for them to understand the risks of this process. A few pros and cons of this process are listed below:
a) Immediate cash flow to expand the business and conduct routine operations
b) Quick and simple process, and businesses don’t have to wait for a long time to get their money
c) No collateral submission is required, as the factoring company is more concerned about the reputation of the customers than the reputation of the business itself
a) No access to full invoice amount for the businesses, as the factoring company deducts a percentage towards processing fee
b) Late payment from customers beyond the invoice due date can lead to increased processing fees charged by the factor
c) A factor may choose to help a business only if the credibility and credit history of its customers are good
Small and medium business owners can significantly benefit from invoice factoring services. However, the key is to choose a reputed and transparent company like Finverv for these services. With reputed financial companies like Finverv, growing businesses don’t have to worry about exorbitant processing charges and hidden costs when receiving their payment. In conclusion, choosing a factor may be the right choice for businesses if they join hands with a professional company and their customers have a good credit history.