Factoring is a form of invoice finance with many pros and cons, and before entering into such an agreement it is wise to understand the pros and cons of factoring. It is not uncommon for a firm to need invoice finance because of their success. They are selling so much that they have to continually buy more raw materials, and maybe even hire more staff, that they run out of cash before the due date comes for payment of invoices.
This sometimes happens with new businesses that grow too fast for them to handle, and the cash flow situation becomes critical. They are unable to pay wages and salaries, and have no money for materials. They rely on credit and hope that the invoices start getting paid before they are pressed for payment themselves.
Invoice finance factoring is a good way for them to free up the cash tied up in invoices, and release it to give them the cash flow they need to be able to continue to expand. However, although that is one advantage of invoice finance, how many more are there and are there any negatives?
Factoring is a way of releasing cash tied up in invoices that is particularly suited to new or smaller businesses that do not have a credit control department. In factoring, a third party looks after collecting payment for your invoices, and all you need do is wait for them to give you the money.
Basically, you invoice your customers with copies also going to the third party. This third party pays you around 80-90% of the value of invoice immediately, enabling you to use the cash for whatever it is needed for. The customer pays the invoice to the factor, which then pays the balance of 10 - 20% to you less their fee. That way, you need not worry about collecting payment since you have the bulk of the cash to use immediately with the rest coming in at a later date.
- Your cash flow remains healthy. It is as close to immediate payment as you can get in this world, and because the money gets to your bank quickly, it helps you to avoid overdraft costs and is available when you need it. You no longer have to wait 30 days and hope that your customer doesn't extend it.
- You save on collection costs: it helps you to avoid the cost of setting up a credit control department because there is no credit. The factor pays you, collects the money and then pays you the balance minus admin fees and interest.
- You can improve your planning because you know exactly when your invoices will be paid. You know that after invoicing for that large order, you can immediately take a new order and kit up for it without having to wait for the cash to come in.
- You can become more competitive in your industry since you are not reliant upon timely invoice payments. You have no added credit collection costs, and can often afford to buy in bulk to keep raw material prices down.
- You can get lower raw material costs through discounts for immediate payment. While your competitors are negotiating extended payment terms with their suppers, you are negotiation discounts.
- Because many factoring forms will carry out credit reference searches on your customers before allowing you to offer them credit terms, you get to know more about the financial security of these customers which is also helpful in your future planning and in future business decisions.
- There is a possibility of you entering non-recourse factoring whereby the factoring company is responsible if the customer cannot/doesn't pay or goes into receivership before paying their invoice. However, recourse factoring, where you take this risk, is cheaper and may suit you better if you are sure of your customers.
In spite of all these attractive benefits, invoice finance and factoring also has some negatives. These are:
- Invoice finance is a form of borrowing: in effect, you are getting a loan with the invoices as security. That costs money in terms of costs and interest, so the invoice factoring service is not free. If customers are slow to pay, you still get paid up front, but you will have to pay more interest on the 80 - 90% advance you are given.
- The factoring company will dealing with your debt management, and your customers may have strangers calling them and pressing for payment. If specific customers are too slow in paying they might not accept any more invoices for them, and you could even be forced to stop trading with some customers against your wishes.
- On a similar note, the factoring company might restrict the risks you take which will involve them controlling the customers you accept on the basis of their credit record. That old guy down the road that you sometimes allow to take 60 days to pay will no longer be an approved customer!
- Unless you agree to the more expensive non-recourse factoring, you may have to pay the lender back any advance they give you within a specified period. If your customer has not paid by that time, you might find the factoring company retaining invoices paid to them until that sum has been covered. Then they can stop you dealing with the defaulting customer.
- Once you have started maintaining cash flow using invoice finance factoring, it is very difficult to stop it and return to a normal business situation. You will be too used to having cash flow immediately you invoice and you might not be able to fund yourself for those 30 days you must now wait for any payment coming in.
Invoice finance factoring appears to be a very attractive option, and so it might be, but keep in mind that there also negatives, a major of which involves you losing control of your business to an extent. Nevertheless, if your company is successful, then you should be able to save enough funds to maintain cash flow while you return to a normal situation - if you want to.
Many are happy to continue with invoice finance factoring as their normal way of handling invoices and their collection.