If you’re looking to start a new business, or if you’d like to expand your current business, cash flow is usually the biggest hurdle.

While going to a bank and applying for a loan seems like the logical solution, it isn’t quite that easy. Many banks are staying far away from helping out small business owners. This is where a service such as invoice factoring can help.

What is Invoice Factoring?

Factoring is when your business sells or transfers its accounts receivables to a third party at a discount. In exchange, the purchasing party will advance your business a portion of the receivable, with the remaining balance being due upon receiving payment from your customer.

The initial advance is usually between 75 and 95 percent, though it can be higher or lower. The remaining balance, minus a fee, is paid to you upon your factoring company receiving payment from your customer.

Because it can often take as little as 24 hours to see a receivable get funded, factoring is a powerful financial product that can help sustain a business during rough patches, or help fuel rapid growth.

What are the Benefits?

Besides receiving an immediate cash advance on your receivables, there are other benefits to factoring.

  • Easier to qualify for than traditional lending – Because factoring is based on your customer’s credit, it is easier for new entities to obtain than traditional bank financing.
  • Outsources accounts receivable and collections – Factoring can effectively outsource your accounts receivable and collections needs in nonrecourse arrangements. This is especially true in small, owner-operated types of businesses where your time is better spent providing your service or obtaining new customers.
  • Transactional/no fixed payments – Factoring differs from a loan because as a transactional product, there are no monthly recurring payments to make.

Are All Invoice Finance Services the Same?

The general concept of factoring is uniform, but there are slight variations to the service that can tailor it to your specific business needs.

The most common type is recourse factoring, which simply means that you maintain liability if your customer defaults on a payment. In recourse factoring arrangements, your factoring company will usually require a reserve account be funded to protect your interests.

Consequently, nonrecourse factoring transfers the liability of non-payment with the sale of an invoice. Fees are much higher in these types of transactions due to the factoring company absorbing additional risk. This type of arrangement can be beneficial for newer businesses that make fewer or irregular sales, where a single customer non-payment could be devastating.

How Much Does Factoring Cost?

Because invoice factoring is a flexible tool, it comes at a high cost. Factoring fees are often times 2-5 percent of the invoice value. This means that if you are charged a fee of 2 percent on a $50,000 receivable, you’ll be paying $1,000 to the factoring company to receive funding 30-45 days sooner than if you were to wait for your customer to pay.

While the costs are high, factoring can still provide a tremendous value, such as in a scenario where your business would normally have to decline a large purchase order due to cash flow restraints that prevent you from obtaining the materials or services required to fulfill it.

Who Uses Factoring?

Because of the nature of the service, factoring is reserved for the B2B sector. It is used in many industries, such as:

  • Trucking/freight transportation
  • Construction
  • Staffing agencies
  • Healthcare/medical practices
  • Manufacturers and wholesalers

The Bottom Line

Invoice factoring fills a void in the business finance world by helping businesses that are experiencing cash flow constraints. Whether it’s a new entity that can’t get financed by a bank or an established business that is going through their slow season, factoring can provide tremendous value.

Roger Grinnell is a freelance writer that primarily writes about small business finance and alternative lending. You can view more of his work at Factoring Journal.