Working capital solutions: AR invoice factoring

SMBs and start-ups that need consistent cash flow month over month or immediate capital to grow turn to invoice factoring for access to working capital. We’ll take you through what invoice factoring is, what it costs, and when to turn to it for financing solutions.

Accounts receivable factoring, or invoice factoring, is an AR solution for businesses that have outstanding invoices for completed work but need cash in the short term. Through AR factoring, businesses are able to receive a percentage of a total invoice immediately for working capital.

How does accounts receivable factoring work?

When a business uses invoice factoring, they leverage their outstanding invoices to an accounts receivable factoring company at a discount value. As a lender, the factoring company will purchase the outstanding invoices, paying a percentage of the outstanding amounts, or advance rate, upfront. Then, once customers pay their invoices, the factoring company pays the business owner the remaining percentage of the original invoices minus any factoring fees. Examples of industries that commonly turn to invoice factoring as a capital solution are staffing services, trucking and freight, construction, manufacturing, and distribution.

Small businesses are especially prone to needing capital to continue to grow early on, but this can be hard to do if clients have not yet paid outstanding invoices. For example, a small business owner with $10,000 in an outstanding invoice who sells the value of the invoice to a factoring company can receive upwards of $8,000 immediately—a number that can be very appealing when cash flow is low. The remainder is held in a reserve account by the factoring company until the invoices are paid in full.

The cost of factoring receivables

There are important costs to think of when considering whether invoice factoring is the right choice. Factors that impact these costs include: the number of unpaid invoices, the total amounts due in those invoices, and risk factors like the creditworthiness of the clients whose invoices are unpaid.

A fee, usually between 1%-4% of the total unpaid invoices, is taken initially. In addition, there are on-going fees the longer the invoices remain unpaid. The two most common factoring costs are: a one-time, all-inclusive fee or a factoring rate. Of the factoring rates, the two most common models are flat discount and flat discount plus margin. A flat discount fee is an additional percentage incurred every 30 days based on the gross amount of the unpaid invoices. A flat discount plus margin model uses a short-term interest rate similar to that used in the US banking system.

What is a factoring agreement?

A factoring agreement is a legally binding contract that a business and factoring company enter into that determines the fees and time-line of the agreement. Factoring agreements are only available to B2B or B2G companies and cannot be used for invoices for individuals.

To enter into a factoring agreement, the business itself must have an AR system in place with net terms established. Once an agreement is in place, the factoring company partners with a business AR team, or seller, to collect payment on an invoice amount. For some, this relinquishing of control in the relationship with a buyer is unfavorable.

It is important to understand the fine print in a factoring agreement which might include customer invoice limits, factoring commissions, sales commissions, and termination fees. Further, some factoring agreements have recourse for invoices that ultimately default, requiring the business to buy back the unpaid invoice. Non-recourse factoring options that eliminate penalties for non-payment are available at higher costs, but may be a better solution in the long run.

The benefits of factoring invoices

For business that need consistent cash flow solutions, invoice factoring ensures capital when it is needed, providing security for growth.

Unlimited potential for funding

Businesses that have work coming in and invoices going out shouldn’t be limited simply because buyers haven’t paid. Using unpaid invoices as collateral for necessities like major equipment, materials or parts, and additional inventory means that your business can take necessary steps, right on time.

No monthly minimums or maximums

Not all factoring companies are built the same. Finding factoring that meets your needs is possible, including those that offer no monthly minimums or maximums. While no-minimum plans can still have limitations on individual invoices, there is desirable flexibility in being able to finance what you need, when you need it.

Get approved even with prior financial difficulty

Whereas business loan financing is determined by credit scores of the business itself, invoice factoring rates are determined by risk factors associated with the buyers whose invoices are unpaid. This means that businesses seeking cash flow are not held back by bad credit scores or having no credit history.

Factoring builds your company's credit profile

Having a strong credit history is important to SMBs. Loans require a credit check that, even if not approved, lowers a credit score, potentially hurting credit lines. Using factoring to access capital means that there is no negative impact to credit scores. Even better, the use of factoring actually builds the credit score by providing the means to eliminate bad debt, paying bills on time consistently—if not early—meaning you can leverage suppliers for improved terms.

Can help companies survive a downturn

Sometimes even the strongest businesses encounter slow times. This can be especially true for businesses that provide services with seasonal fluctuations: distribution channels that boom around the holidays or event staffing agencies that fill festival grounds in the summer. Being able to navigate low cash flow issues with the use of invoice factoring means receiving earned revenue and staying on top of important AP cycles.

The disadvantages of factoring receivables

Invoice factoring, while very beneficial, can include high costs that are a barrier to some.

High fees

Understanding fees included in a factoring transaction is vital to choosing the best option for your business. For example, consider the differences of factoring fee v. rate models. While the one-time payment may feel like the best and least complicated option, it may be more costly over time than other factoring rate options. Conversely, rate models can slowly chip away at invoice collateral.

Best practice would be for a business owner to weigh the benefits of having immediate access to cash flow against the amounts relinquished to factoring fees and rates. If the outstanding receivables are from sources that are known to make reliable, timely payments, the risk of incurring month over month rates from a factoring company is low. However, if the vendors you work with have a history of paying late or not paying in full, this will directly impact the cost of factoring and may not be worth it.

When to leverage accounts receivable financing

Businesses have a number of different financing options to fund their big-picture expenses. There is a strategic advantage to knowing when to turn to AR financing or other asset-based lending as a solution.

When you need capital for bigger projects

It can be an exciting time when a big contract is awarded, but with bigger projects come sizable up-front costs to complete the project. Being able to turn the value of unpaid invoices into needed capital ensures business growth.

You don't qualify for traditional bank loans

Small businesses can have difficulty getting a needed loan from their bank. For some, it is simply because their business is too new and there is no credit history, making them a credit risk a bank is not keen to finance. For others it is because they’re in a risky industry like restaurants or because they have no collateral to offer. AR financing gives your business access to cash flow you’ve already earned without a rejection bottleneck.

You need multiple sources of capital

Different sources of capital are needed at different times. When your business needs funding, it is important to ask if the need is immediate or long term. For more immediate cash flow, AR financing can be a more viable solution whereas larger loans are more beneficial to long-term needs. In either case, knowing there are multiple options available to business owners beyond traditional lending offers confidence to new and experienced owners alike.

Conclusion

SMBs and start-ups desire credibility, access to working capital, and the ability to say Yes! to growth.These benefits of accounts receivable factoring can give your business the leverage to grow when you want or the security to carry your business through a downturn. By making smart choices in selecting the right factoring company partner, your business will be able to navigate both.