How Does Invoice Factoring Work?
BY: BERNADINE RACOMA ON TUESDAY, APRIL 10, 2018
It goes without saying that many of us aspire to become business owners. Being our own boss and having others take on the tasks required by the company instead of doing them on our own is something that we’re all eager to have. The added bonus of better income than the general salary of regular employees is nothing to scoff at either. The common misconception, however, is that being the top dog is easy. Nothing could be farther from the truth.
Apart from having a solid business model that yields the desired monetary gains, there are plenty of other complexities that go into running a company. One of these is invoice factoring. As a type of a financing option, it can be especially beneficial for smaller businesses or those in dire need of additional capital and can make all the difference in keeping a company afloat through financial troubles.
But before the process of how it works can be explained, it is essential to know exactly what it is.
What exactly is invoice factoring?
You will rarely come across an established business or enterprise that at one point in time has not needed financial support to keep everything in working order. To this end, invoice factoring exists as a means to acquire short-term finance. What this basically does is supply the company with some working capital by trading the allocation and sale of invoices to the designated factor.
A certain amount of the value of the invoices, usually around 80 percent or so, is forwarded to the company in exchange, as an advance. Once everything has been fully paid, the remainder is then given back by the factor minus all the fees associated with the service. While it can often be confused with invoice financing, which is another type of accounts receivable finance option, the difference lies in the invoice factoring’s need for the actual invoices.
When it comes to short-term cash concerns and issues, invoice factoring works well as a viable financial solution. However, this option isn’t normally used for larger investment projects that usually call for long-term loans and should only be utilised as a temporary solution.
How does the process work?
There are a few steps in the process of invoice factoring, it all starts with qualification. One of the first requirements is to ensure that invoices associated with products sold or services rendered by a business-to-business or business-to-government client must be payable within a 90-day limit. There are usually other criteria involved that are determined by the factor, but almost all will require the same time frame.
The next step is to look for a factor and go through the application before selling the invoices. This is where the eligibility of the transaction will come into play including but not necessarily limited to checking the credit risks of the customers involved. Once the chosen factor approves, all of the financial paperwork will be produced and signed. This agreement will also dictate the highest amount that can be initially borrowed which is usually the maximum outstanding value of invoices.
After all the formalities have been handled, the factor then provides the monetary amount agreed upon by both parties, called the advance rate. Generally, this amount is determined by the industry that your business is in, the size of the actual transaction in its entirety, and other elements. At this point, you or the factor themselves will issue what is called a notice of assignment, meaning that the customers will be sending out payments for the assigned invoices to the factor instead.
It is important to take note that not all industries may be accustomed to this form of financing option. It is not uncommon for issues to surface when letting your clients and customers know that their invoices have been assigned to an external, third-party entity. In this case, it may prove to be a better method to go for invoice financing instead since it doesn’t require the allocation of the invoices.
Balance and payment
Based on the terms of the agreement between your company and the factor as well as the invoices, the client will and should pay within the required 90 days given. The reserve amount or the balance left from the paid invoices will then be given back to you with the fees for the services rendered deducted from the total amount.
One reason why invoice factoring has become a viable financing option is the ease of qualification when compared to its longer-term financing counterparts. While profit, as well as credit scores, are still elements that most factors will consider, they aren’t quite as heavily focused as they usually are with other kinds of financial alternatives. This makes the entire process a lot more streamlined and even less tedious too.
To qualify, the invoices must have been sent to business or government clients, or B2B and B2G, respectively, as they are more commonly known. Their credit risks must also be at a minimum as the factor will undoubtedly proceed if they are comfortable that the customers will pay them. The business involved, including your own, must also not have any legal or tax-related problems either.
More importantly, the invoices must be paid on or before the 90th day and should not be placed atop any other pre-existing loans as this can cause complications regarding the payment needed for both parties.
Is invoice factoring the right way to go?
The utilization of invoice factoring as a financial option depends on a lot of factors, from industry familiarity and qualifications to the time frame you are working with. As effective a financial strategy as it may be, some factors may or may not provide their services based on the elements involved. There are also other options that can be used, so it is imperative to do research and check what process will benefit your company the most.
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