It’s not uncommon for businesses that invoice their clients to find themselves in a financial bind while they wait for their clients to pay them – which is typically between 10 to 30 days, though it may even be longer. For companies that have access to more capital, this may not be an issue, but for smaller businesses or those that are just starting out, waiting for clients to pay their invoice can grind business-as-usual to a halt.
For companies that find themselves in this situation, a factoring company may be the solution. Invoice factoring can help a business get a boost of cash quickly, and with less paperwork and restrictions than a bank might require.
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What is factoring?
Factoring is a means of unlocking the cash caught up in unpaid invoices. A factoring company gives a cash equivalent on a percentage of your unpaid invoices. Then they set to work collecting on those invoices. When an invoice is paid, the factoring company gives you the cash – minus a percentage for its services.
In some instances, factoring is a better choice than a bank loan. There is less paperwork involved in working with a factoring company than there is with a bank. Companies can get cash much more quickly. And because factoring companies are collecting against your invoices, they are more interested in the creditworthiness of your clients than your credit score. Even if your credit isn't perfect, a factoring company may still help you out.
Of course, there are downsides to factoring. Factoring is a type of loan, so if your customers don't pay the factored invoices within an agreed-upon amount of time, you'll need to pay back the outstanding debt.
Factoring can also be expensive. It can cost several percentage points more than what a conventional loan would charge. It's also likely a factoring company may charge per invoice. If you have many small, unpaid invoices, factoring may be too expensive.
There are times, however, when factoring makes a great deal of sense, and is worth the financial risk and impact. [Want to learn more about factoring services? Check out our best picks.]
Industries that commonly use factoring
Here are some of the types of businesses that use factoring to get the funding they need to keep their businesses running:
- Transportation and trucking
- Freight brokers
- Construction companies
- Staffing agencies
- Commercial food services
- Janitorial and cleaning companies
Why use factoring services?
Modern business moves swiftly, and sometimes opportunities appear and disappear fast. For instance, imagine you had the opportunity to land a large new client, but only if you could provide inventory very quickly. Your manufacturing processes are up to the challenge, but you're short on materials. If you had cash, you could ramp up and deliver for the new client. Factoring may give you the cash you need to seize the opportunity, knowing that you'll be making back any money lost on fees with the new client.
When considering options to improve your cash flow in the short term, there are a few instances when factoring becomes the logical choice. Here are some good reasons to consider using a factoring service:
1. Ensure employees get paid
Sometimes companies use factoring simply to keep the business moving forward. If waiting on an invoice is putting your payroll at risk, it may be worth it to use a factoring company to ensure you can pay your employees, using the money from the factoring company as a stopgap measure.
2. Improve cash flow from slow-paying customers
Factoring can be especially effective if you have a large, well-known client who is slow to pay. Because your client is a good credit risk, a factoring company is likely to take on the invoice. The money can help you bridge the time between when the invoice is given over for factoring and when the invoice is paid.
3. Maintain positive relationships with clients
It's also a way to maintain a good relationship with a client you want to continue to do business with. Sending an invoice to a debt collector may sour the relationship, but a professional notice to a client informing them that their invoice is being factored can keep the relationship solid while putting cash in your business's bank account. [Read related article: How to Manage Accounts Receivable (and What to Do When Clients Won't Pay]
4. Meet short-term cash needs
Factoring can be a boon for companies with short-term cash needs. It's a quick and relatively easy way to inject cash into the business for short-term expenses and growth. As with any business loan, though, factoring should be approached with caution. Carefully consider the terms and use only when it seems like an acceptable business risk.
5. Avoid a loan or line of credit
In most situations, getting a loan or line of credit from a bank or credit union is the cheapest way to quickly finance a business. However, not all business -- or business owners -- meet the minimum requirements to qualify for a loan. Working with a factoring service allows you to quickly receive funds, even if you have a low credit score, outstanding debt, or do not otherwise qualify for a traditional loan. [Read related article: Loans You Can Get With Bad Credit]
Costs of using factoring services
When you start looking for a factoring company to partner with, there are two specific rates you need to identify: the advance rate and the factoring rate.
The advance rate is the percentage of an invoice you will receive when you submit it to the factoring company. The advance rate can vary depending on your industry, but usually begins at 70% and may go as high as 95%. The factoring rate is what the factor charges you for their services. This rate can also vary depending on your industry, but they usually start around 1% and can go as high as 5%.
In most cases, factoring companies use one of two types of pricing structures: fixed-rate and time-based. Here's how these pricing structures differ:
This pricing structure is simple and straightforward. With this structure, the factor quotes your business a flat rate for their services, regardless of when your client pays their invoice. Not all factoring companies offer a fixed rate, but if your customers are reliable and pay consistently, you can find this type of agreement with a factor.
Example of a fixed-rate fee:
Assume a factoring company charges a 2% fixed rate factoring fee and has an 85% advance rate. If you were to submit a $1,000 invoice to the factor, you would receive $850 in one to three business days. When your client pays their invoice, you will receive the rest of the invoice, minus the 2% factoring fee, which totals $20.
The time-based, or variable-rate, structure is the most common type of pricing standards in the factoring industry. It’s also slightly more complicated. With this type of contract, the factoring rate is based on how long it takes your client to pay their invoice. So, if your client pays quickly, your fee will be lower. If it takes a customer months to pay their invoice, the cost adds up quickly. Time-based rates can vary based on the line of work you are in, but they usually follow one of these formats:
- 1% every 10 days
- 2% every 20 days plus 0.25% every day thereafter
- 3% every 30 days plus 1.25% every 15 days.
Example of a time-based fee:
Assume a factor charges 1% every 10 days and has a 90% advance rate. If you submit three $1,000 invoices from three different clients, you will receive $900 from each invoice in one to three business days. The first client pays in five days, so the factor releases the rest of the invoice minus their fee, which is $10. The second client pays their invoice in 11 days, so you are charged $20. The third client pays 40 days after the invoice was submitted, so you are charged $40.
Additional reporting by Dawn Kuczwara.