Invoice factoring is a type of financing that allows business owners to get paid faster on invoices for work they’ve already performed. While factoring isn’t ideal for all industries and is more expensive than other types of financing, it’s a great option for many business owners in certain industries or with certain credit profiles.
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Invoice factoring is important because it offers fast funding for businesses that qualify. In these cases, by working with a factoring company, you can effectively sell payments you’re owed for outstanding invoices and shift your risks to a factoring company if your client pays late or fails to pay their invoice.
Invoice factoring is a business financing tool that offers quicker funding than many other types of loans. Factoring also makes it easier for business owners with questionable credit to get funding, because the owner’s credit isn’t really important – it’s their clients’ creditworthiness that matters.
[Read Related: Financing Options That Bypass Traditional Banks]
With these advantages, invoice factoring is especially prevalent in industries that don’t lend themselves well to conventional financing solutions, such as these types of businesses:
Only companies that invoice clients are eligible for factoring, so the factoring process starts with your business performing work for a client. Once the work is complete, you invoice your client. If you decide you need cash faster than the client typically pays you, you can apply with a factoring company.
After your business is approved to work with a factoring company, you identify the individual invoices you want to borrow against. The factoring company then vets the client to make sure they have a strong history of paying their invoices.
If the factoring company approves the invoice, you assign the invoice to the factoring company. The factoring company then advances your business a portion of the money you’re owed on the invoice (typically 80% to 90%).
Once you receive your advance against the invoice, you can use the money however you want – such as for expansion, equipment or payroll. The factoring company takes responsibility for collecting the invoice, and after your client pays the full invoice, the factoring company sends you any funds left after the loan is repaid, along with interest and any other fees.
Invoice financing and factoring are similar but have several key differences. In order to use invoice financing, you have to apply with a lender and get approval to borrow against certain invoices. You can then get an advance on the amount your client owes you.
However, when you use invoice financing, your business is still responsible for collecting on the invoice. Once you do, you use the payment to pay back your loan, plus interest and fees. After you’ve repaid the loan, you may be able to borrow against other invoices.
With invoice factoring, on the other hand, you effectively sell your invoices to a factoring company. [Read Related: Bootstrapping or Equity Funding]
These are some other key differences between factoring and invoice financing:
So, while factoring typically allows you to borrow against any outstanding invoices you’ve sent to approved clients, invoice financing has an underwriting process much more similar to conventional loan products.
Invoice factoring is one of the easier types of financing for businesses to qualify for, and it allows you to get cash very quickly – much faster than most client companies pay their invoices. The downside is that factoring is one of the most expensive forms of business financing available.
The costs of factoring can be much higher than for other types of financing. There are often some ways to reduce costs, but these vary by factoring company. For example, borrowers in certain industries (such as healthcare) may receive lower interest rates than others. You may also save money if you handle payments electronically. Of course, the sooner your clients pay their invoices, the lower your fees will be.
[Looking for additional funding options? Read: How to Get a Bank Loan for Your Small Business]
While there are several advantages to using factoring as a form of business financing, it also has drawbacks. These pros and cons make factoring ideal for some businesses in certain industries and a poor solution for others.
This last point is worth highlighting, because when you factor an invoice, you effectively sell that invoice to the factoring company and give up any right to collect payment yourself. Even though you can’t ensure the collection of the invoice, the interest you pay is based on how long it takes your client to pay the invoice.
Like other lenders, factoring companies come in all shapes and sizes. Each has its own strengths and limitations as well as specialties. If you think invoice factoring may be a good way to help you finance your business, consider these aspects being picking a lender:
Invoice factoring is a fast, easy form of business financing for certain qualifying businesses. While factoring involves higher interest than many other types of business financing, the right factoring company can be a great partner to give you quick access to cash for work you’ve already performed, helping you operate and grow your company.