What is invoice factoring and how does it work?
Invoice factoring is a process by which businesses use their unpaid invoices to smooth out cash flow requirements by having a third party, usually a financial organisation known a ‘factoring company’, buy their invoice at a discount from the face value. Here’s how it normally works:
The third party financial organisation will generally transfer around 80% of the unpaid invoice value (less their service fee) to its customer who has issued the invoice and collect 100% of the invoice either directly or indirectly (the client may have to collect the funds and transfer them to the factoring company). Once collected the factoring company will return the remaining amount of the invoice that was not advanced, known as the 'retention’, (around 20% subject to the percentage they have already funded) minus their interest cost.
Debtor example for an invoice paid at 30 days
- a) Invoice Amount = $10,000
- b) Advance Amount (80%) (a x 0.8) = $8,000
- c) Advance Fee (2.75%) (a x 0.0275) = $275
- d) 0-30 Day Fee (2.00%) (a x 0.02) = $200
- e) Initial payment to client (b - c) = $7,725
- f) Balance Payment ((aX20%) – d) = $1,800
- g) Total Fees = $475
Advantages of invoice factoring
If your business does not issue invoices with payment terms (i.e. cash on delivery), then this form of finance is really not for you - and like an episode of Jerry Springer, it would be best to observe and not participate.
If you do invoice on payment terms then this form of finance can help to your cash flow and even more so if your debtors are perennial late payers.
A May 2018 Report by MYOB on Australian Businesses found that 40% of Manufacturing and wholesale businesses and 37% of construction and trades businesses found Cash Flow to be a pressure point effecting their business operations.
Rather than taking out a long term business loan or redirecting cash flow that was going to be used to grow your business it may be better for your bottom line to ‘sell’ an invoice or invoices to a factoring Company and have the loan repaid when your debtor pays.
A smoother cash flow will hopefully allow you to engage in paying suppliers on time, ensure timely payment of payroll (and avoid disgruntled employees), focusing on customer retention and acquisition initiatives or pursue business opportunities that require immediate access to funds that weren’t previously budgeted for.
Disadvantages of invoice factoring
Whilst getting access to additional cash flow is an attractive option to any business, you should consider the below before going ahead and applying for a facility.
Invoice factoring companies often charge a premium for the flexibility of factoring a particular invoice or invoices, which can result in clients paying more in fees than in equivalent ‘whole ledger’ factoring facilities where all debtors or a large portions of debtors are factored on a reoccurring basis, which can be a more cost effective option, based on the individual circumstances of the business.
Negotiating better payment terms with your debtors can at times be a more effective way of dealing with cash flow problems rather than using a factoring company to unlock the value of invoices.
Late fees and arrears interest can at times be excessive for perennial late paying debtors. Whilst not always the case the arrears interest charged may be worth incurring depending on the opportunity gained by factoring the invoice.
A difficulty a lot of SMEs face is having household name Companies as their debtors who use their industry reputation and power to dictate payment terms which can be in excess of 120 days. This can prove quite costly as the longer the invoice remains unpaid, the more interest the business has to absorb.
Things to consider
Rightly or wrongly there is a negative connotation that having a factoring facility means that your business may be in an adverse financial position. Whilst there are different opinions on this subject matter this problem can be avoided by finding a factoring Company that allows invoices to be sold on a confidential basis, whereby debtors are not aware of the arrangement.
You’re not alone:
The same MYOB survey referred to earlier reported that 63% of business owners and managers would vote favourably in relation to Government policies committing Government and big business to pay small businesses within 30 days.
Questions about Invoice Factoring?
For more information on Finstro's Invoice Factoring solutions, click here:
Finstro Fund | Invoice Factoring.
Questions about Business Finance?
The information contained on this web site is general in nature and does not take into account your personal or business situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a business adviser or Accountant.