Invoice Factoring For Small Businesses
Improve your small business's cash flow with invoice factoring
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Thought invoice factoring was only for multimillion-dollar businesses? Not anymore. Here's how factoring can benefit your small business.
Small businesses in Australia have a number of finance options available to them. Debtor finance is a way of accessing funds by using your business's outstanding invoices as security. It comes in a number of varieties, with invoice factoring being one of them.
Rather than waiting 30 or even 90 days for your client to pay their invoice, debtor finance allows you to "sell" the outstanding invoice at a reduced rate, and enjoy the cash flow benefits of having access to the invoice amount before the client pays it.
Read on to find out how invoice factoring could help improve the cash flow situation of your small business as well as what you should look out for.
Compare invoice factoring options for small businesses
Understanding invoice factoring
How does factoring work?
Invoice factoring is where a lender (also known as a "factor") purchases trade debts owed to the business. After you render an invoice to a client, you will receive a percentage of the invoice amount from the factor. Once the invoice has been paid in full by the client, the lender will take their fee and release any remaining money directly back to you.
How much can I borrow?
You will typically be advanced up to 80% of the invoice before it is settled by your customer. Some lenders will extend up to 85% with some strong, reputable businesses able to borrow up to 90% if they can prove that the invoice is low risk. Low-risk invoices can include invoices of low amounts or if your business is in a strong financial position with a clean credit history. If you have a borrowing history with the invoice factoring company then you may also be advanced more before your customer settles.
Invoice factoring fees
Fees for invoice factoring are typically a set fee based on the total amount of the invoice (sometimes up to 2.5%), combined with an interest rate (generally between 8% and 14%). While the fee is fixed based on the amount of the invoice extended to you, the interest rate is applied to the amount of time it takes for the invoice to be collected.
Fee structures can vary significantly between different companies, with some lenders combining set fees and interest rates into one factoring fee. These differences can make it difficult to compare the fee structures of different factoring companies, but it is vitally important that you understand the full cost of invoice factoring before entering into an arrangement.
Other fees may be charged, and this can vary significantly from lender to lender. You also need to be aware of the contract arrangements as long-term contracts for invoice factoring are common. Contract lengths vary and are usually negotiated with individual businesses. Check whether additional fees, charges and penalties can apply and whether any extra fees or penalties apply for leaving a long-term contract or not providing a minimum number of invoices on an ongoing rate.
Before choosing invoice factoring, calculate invoice financing costs and compare these costs to other forms of small business lending to ensure that you are getting the best deal for your circumstances.
Advantages and disadvantages of invoice factoring for a small business
When investigating an invoice factoring arrangement for your small business, consider how the following advantages and disadvantages may apply to you.
Advantages of invoice factoring:
- Eases cash flow. Invoice factoring can provide substantial cash flow benefits to any business.
- Helps small businesses especially. Invoice factoring can be most beneficial for small businesses that tend to work with a small number of clients, particularly those who bear the financial burden of performing months of work for a client before rendering an invoice.
- Take advantage of opportunities. Invoice factoring can allow small businesses to take advantage of time-sensitive opportunities, such as purchasing discounted stock or equipment or purchasing items necessary to put in a tender for a large project.
- Quick access to funds. Funds are usually extended in a very short period of time, sometimes within 24 hours, after the invoice has been rendered and assigned to the factoring company.
Disadvantages of invoice factoring:
- Costs. Every form of small business finance comes at a cost, and invoice factoring is no exception. Lenders will charge interest on the amount extended in addition to other fees which can include service fees and management fees. Some factoring companies will also impose minimum terms or exit fees.
- Business reputation. As a small business owner, you may be concerned about your business's reputation if your clients know you're using an invoice factoring service. Read on for more information about confidential factoring arrangements.
The difference between debtor finance and invoice factoring
As mentioned previously, invoice factoring is a type of debtor finance. At first glance, invoice factoring and other types of debtor finance appear to be similar forms of small business finance. In both, a third party steps in after an invoice has been rendered and pays the majority of the invoice amount directly to the business. However, this is typically where the similarities end.
- Debtor finance typically involves businesses entering into an agreement for all invoices to be collected by the lender. With invoice factoring, the business can choose to factor some invoices and not others at their own discretion. For example, if you're in a good cash flow position and are dealing with a strong client who always pays on time, there would be no need to enter into an invoice factoring arrangement for that particular client.
- Debtor finance is also confidential when compared to invoice factoring. With debtor finance, the business's clients are unaware that the invoice will be collected by a third party. Invoice factoring usually involves notification being made to your clients that the invoices will be collected by a third party; however, some factoring companies do offer confidential invoice factoring.
- Debtor finance has the option for debt collection services, whereas debt collection is usually seen as a vital role of the factoring company in an invoice factoring arrangement.
From your client's point of view
As a small business owner, maintaining a good relationship with your clients is vital. How will an invoice factoring arrangement affect your clients?
As mentioned above, some forms of debtor finance are confidential arrangements, so your clients won't know that they're paying a third party rather than you directly. Invoice factoring, on the other hand, is usually an open arrangement. This means that your clients will know that they're paying their invoice to a third party, rather than to your business. You will need to provide your clients with the bank account information or other payment details of the factoring company, and they may even be contacted directly by the factoring company to chase up payment of the invoice.
You may have mixed feelings about this type of arrangement. On the one hand, having a third party help collect payment of the invoices could result in faster and more reliable payments. On the other hand, might your client wonder if you're experiencing financial difficulties if you're working with an invoice factoring company? This is something you'll need to consider when weighing up your decision. Consider speaking with the factoring company to ask about a confidential arrangement, whereby your clients wouldn't know that you're working with a third party factoring company.
Accessing factoring for small business owners
Despite invoice financing becoming more accessible to small businesses in recent years, it can still be difficult for some businesses to qualify with certain lenders. As with any other type of finance, it is always a good idea to compare your options to see if one lender may be a better fit for your circumstances than another.
Eligibility criteria differ between factoring companies, but the following qualifying criteria may apply:
- Projected annual turnover of at least $50,000
- Invoices aged less than 90 days
- Few or no trade disputes
- Invoices not related to stage or progress payments
- Invoices rendered on normal credit terms for that business
- Your business has good credit. Bad credit may be mitigated by higher fees
Proving your business income
A factoring company will assess the income of your business before making an offer. You'll need to provide the lender with financial information of your business, including bank statements, tax returns and projected cash flow statements. Some lenders will ask to see up-to-date income statements directly from accounting software like MYOB or Xero.
Alternative business finance options you can consider
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