Without cash flow, it’s only a matter of time before a business will close its doors. Right behind building a clientele base, invoicing is an important step in creating and maintaining positive cash flow over the long term. For businesses looking for a faster way to collect on invoices, factoring might provide another avenue to quickly generate cash flow.
Factoring works by letting companies receive an advance on their billing invoices, between 70 percent and 90 percent of the original amount, within 24 or 48 hours of application. The company advancing payment for the invoices, called the factor, often makes this loan conditional upon a credit check of the invoiced client. The greater the invoiced client's credit rating, the more likely that the factor will be approved. The final step is when the invoice is paid by the client: the factor pays the balance of the invoice, minus their factoring fee.
Types of Factoring
It's important to note there are two types of factoring – recourse and non-recourse. Recourse factoring is more widely used and often cheaper. Recourse factoring makes the business owner responsible to refund any unpaid invoices to the factoring company if invoices remain unpaid after an agreed upon time. Non-recourse factoring often does not require the entrepreneur to refund any outstanding invoices a factor is not able to collect on. However, the decreased liability businesses have with non-recourse factoring are accompanied by more thorough and higher criteria for credit checks.
Since one of the factors banks look at is a business' creditworthiness, factoring may provide startups with another avenue for quick cash flow if traditional lending is not an option. For early stage companies that want to consider another type of financing, factoring may be an attractive option if they don’t have adequate personal credit, enough business collateral or long enough operating history to meet a lender’s criteria.
While factoring has its advantages, there are some considerations to think about before going ahead with the process. If there are a large number of invoices, service fees can accrue quickly when they go through the risk-worthiness review phase. In addition to the processing and review fees, there are application, credit check and overdue fees (for overdue invoices) that can account for the factoring’s cost.
One test to determine if factoring is right for you is to look at past labor costs. This can be accomplished by analyzing how many hours were used for in-house collection efforts taken to recover outstanding invoices. Metrics for collection efficiency can be compared against common late timeframes of 30, 60 and 90 days. A simple test like this can be implemented as a cost benefit analysis between internal collection efforts versus selling invoices to a factor.
The choice and necessity to use factoring for a company’s invoice is one that isn’t always considered, but for the right type and stage of a business, this service can provide a jumpstart for frozen cash flow. With proper due diligence in choosing the right company, factoring can be a temporary solution to keep a business moving in the right direction over the long term.