Invoice factoring is the process by which a business of any type or size sells its accounts receivables to an invoice factoring company for cash. The purpose of invoice factoring is purely financial. Invoice factoring has several advantages, but the primary reason it’s utilized is that it allows a business to accelerate its cash flow so it can maintain business operations, pay bills, meet its payroll responsibilities, and pay in full and on time for all other operating expenses.
Invoice Factoring Does Not Involve Loans or High Interest Rates!
The general concept of invoice factoring is not overly complex. It does not involve any type of loan that must be repaid, nor does it require the payment of interest on borrowed money. Instead of loaning money to a business, a factoring company purchases the business’s invoices at a dollar amount lower than the amount due on the invoices. After the invoices are purchased at a discount, it is up to the factoring company to make sure the invoices are paid by the debtors.
The factoring company ultimately makes money from transactions when the full amount due is collected from all (or a majority) of the debtors. The purchase price of invoices as well as any other fees the factoring company charges businesses for its services can vary depending on the size of the business, the number of invoices involved in the transaction, the total dollar value of the invoices, and the overall risk associated with the deal. The terms of the agreement between the factoring company and the business can sometimes be slightly negotiable.
Invoice factoring is a tool that is available to a business in need of quick cash. Oftentimes, a business needs immediate cash to pay its operating expenses and employee salaries or to pay for expansion or growth. Factoring invoices allows a business to continue functioning even when unpaid invoices remain outstanding. In other words, a factoring company allows a company to raise cash quickly without forcing it to take on excessive debt. Selling invoices at a discount to a factoring company is a concept that has been around for many years because it is a tried and true financial tool that can allow a business to operate in the most effective manner possible.
Recourse vs. Non-Recourse Factoring
In most cases, a factoring company and a business will make an agreement to utilize one of two methods of invoice factoring: recourse or non-recourse.
Recourse: When a factoring company makes an agreement with a business to utilize the recourse method of factoring, this means the factoring company will attempt to collect the amount due on all outstanding invoices for an agreed upon period of time (sometimes up to 90 days). If any invoices remain outstanding past the agreed upon period of time, the business must buy the outstanding invoices back from the factoring company. A factoring company is more protected with recourse factoring because the business is assuming all of the risk when invoices are unpaid.
Non-Recourse: A factoring company accepts more risk with a non-recourse agreement than it does with a recourse agreement because the factoring company is responsible for collecting what is due on all the invoices it purchases. In other words, once invoices are purchased from a business, the business is no longer responsible for them. If any invoices remain unpaid, the factoring company must cover the cost paid to the business for those particular invoices. There are two types of non-recourse situations: one involves a disputed transaction and the other involves dealing with credit and/or bankruptcy. Every non-recourse agreement between a factoring company and a business covers the agreed upon terms. For example, some agreements require that the business cover any unpaid invoices that remain unpaid due to disputed transactions. In most cases, however, a factoring company remains responsible for any type of credit-related issue with unpaid invoices, including bankruptcy.
There are pros and cons for both a factoring company and a business when it comes to choosing recourse versus non-recourse agreements for invoices. Because there is more risk for an invoice factoring company with non-recourse factoring, a business is sometimes offered a slightly lower purchase price for the invoices because there is no guarantee that the factoring company will collect full payment on every outstanding invoice. In contrast, recourse factoring usually requires that invoices be purchased at a higher price because the business is ultimately responsible to cover the balance for any invoices that are not collected. Issues that should be considered when deciding whether to choose recourse versus non-recourse include a business’s historical percentage of unpaid invoices and the average dollar value of each invoice.
Why Use a Factoring Company?
There are many reasons that a business might consider invoice factoring as a viable option to assist with any cash flow issues it might be experiencing. Oftentimes, the owner of business with either temporary or consistent cash flow problems gets overwhelmed by the situation and doesn’t know the best way to turn things around. Sometimes a business owner will opt to enter into a financial agreement that is complicated or involves taking on considerable debt. With invoice factoring, a business does not have to assume any type of debt.
It is important to keep in mind that the invoice factoring company is in the business of collecting payments on invoices – no matter whether the invoices are current or past due. A reputable factoring company has years and years of experience with specialized collection tactics. A business that utilizes a factoring company is typically very good at producing specific goods or supplying a specific type of service, but it is not necessarily experienced at collecting unpaid invoices. It can be very time-consuming and therefore extremely expensive for a business to maintain a staff that is solely dedicated to collections. Even though an invoice factoring company charges fees for its services, the fees are often less costly than hiring a staff of collectors or never receiving payments for invoices that might have been collectible by employees of an invoice factoring company.
Editor’s Note: Greg Curtiss is President of The Invoice Bankers. Mr. Curtiss previously was a lawyer and has passed the CPA exam. He has been in business for over 25 years. You can reach him by calling 303-740-7600 or 1-888-740-1750.