A business can often find itself in a position where it requires cash for immediate expenses. But collecting payments from customers on time is one of the biggest problems faced by a small business. It often takes months for a customer to come up with the money they owe. There are two ways to speed up this process of collecting outstanding payments: invoice factoring and invoice discounting.
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The financial services of invoice discounting and factoring help a company free up funds by turning unpaid invoices into cash. Both of these methods allow an indebted business to get loans against invoices that are either past due or yet to be due. The lender, in both cases, extends a line of credit that is equal to a specified percentage of the business’ sales ledger. However, the company only pays interest on the amount of cash withdrawn from the line of credit.
These are a set of techniques that enable a small business to borrow against the value of unpaid invoices. In an invoice finance arrangement you raise a normal invoice and pass it on to a third party. This third party then pays you a portion of the face value of the invoice. When the invoice gets paid, the third party finance company gets paid as well.
This process entails the selling of invoices to a factoring company for immediate cash. The company that has bought these account receivables acts as an outsourced credit department and handles the collection and processing of the invoices. Invoice factoringhelps small business raise cash on an immediate basis and reduces the time spent in managing payments and making collection calls.
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Benefits of Invoice Factoring
This system allows companies to grow their working capital in tandem with the sales. Unlike a bank loan where the line of credit is limited to the business equity or the cash flow, factoring provides companies a source of funding that is only limited by sales growth.
This helps small businesses obtain better terms from their suppliers by paying cash within discount periods. It increases the purchase inventory for the businesses as well as allows them to meet payroll and assorted overhead. Invoice factoring does not increase the debt position of a company and is dependent on the client’s creditworthiness, not the company’s. This helps the company generate cash on an immediate basis instead of having to wait for the customer to make the payment.
Businesses That Typically Use Invoice Factoring
The factoring company places the emphasis on the quality of the factoring client’s invoicing documents. Businesses that use these services need to have business-to-business sales. Generally, factoring clients offer payment terms between 30 to 90 days, although they may vary according to different industries. This process also entails the company to sell the products on a “final sale” basis instead of guaranteed, consignment, or contingent sales.
This service is usually availed by:
- Temporary staffing companies
- Transportation companies
- Manufacturing companies
- Commercial janitorial companies
- Security guard companies
- Construction companies
- Landscaping companies
- Distribution companies
- Oil and gas companies
Similar to factoring, in this process the invoice discounter advances an agreed percentage of the invoice value, usually 80-90 percent of the total amount. Unlike factoring, invoice discounting does not allow the customer to know of the arrangement and the supplier is in charge of all the sales ledger administration. Invoice discounting can be extended only to companies that provide goods or services between one business and another on credit. In that aspect, invoice discounting is used by the same industries that use invoice factoring.
Benefits of Invoice Discounting
This process helps increase the cash flow to a small business and enables a company to grow at a faster rate. It helps release cash into the company when required; for example, when payments are due to a supplier. Because the customer is unaware of the discounting process you have commenced, it gives you a chance to maintain your relationship with the client. The funding limit for invoice discounting is limited only to your credit limit, which grows with the growth of your business.
Types of Invoice Factoring and Discounting
- Recourse factoring: In this the finance provider manages the sales ledger with no credit protection, which means that if the customers default, you are liable for all credit costs.
- Non-recourse factoring: In this, the finance provider takes complete responsibility of the sales ledger and bears any risks associated with bad debt. This helps the business do away with the hassle of customer defaults.
- CHOC’s: Factoring, usually, is a disclosed arrangement with the credit control being outsourced. In CHOC’s, Client Handles Own Collections, the facility keeps the business in charge of their sales ledger, making it a far more cost-effective solution for SMEs with in-house accounting systems.
- Recourse invoice discounting: In this the finance provider manages the sales ledger with no credit protection. If a customer defaults on the payment the finance provider reclaims the cash extended.
- Non-recourse invoice discounting: This helps you retain full control of your credit system in addition to the financer providing you bad debt protection.
- Disclosed invoice discounting: In this the customers are notified of the lenders’ involvement.
Choosing an Invoice Finance Provider
For many businesses invoice financing is the best way to have a healthy cash flow and minimize their liabilities. It is important to do a background check on the reputation of the financer you are hoping to work with. Typically, a funder would provide up to 85 percent of the invoice value within 24 hours, but it is always wiser to compare the percentages offered by different funders side by side. Check how closely your funder will be involved with your business and your customers. It is important to know the financial health of your funder before getting into anything. Some funders are more flexible than others, or offer a higher percentage up front. Shop around before you make a final call.
A healthy cash flow is the blood of a strong business. Invoice finance is one of the best ways to ensure that this continues unabated.
Andrew Cravenho is the CEO of CBAC Funding, innovative invoice factoring for small business. As a serial entrepreneur, Andrew focuses on helping both small and medium-sized businesses take control of their cash flow. Prior to CBAC, Andrew founded an annuity financing company relieving tort victims of financial hardship.