Definition of Invoice Factoring
The waiting period between the sale of a product and receiving the payment can be frustrating for many companies. The period may impact the smooth running of the company. Instead of applying for a loan to fill the gap, a company may consider invoice factoring.
Invoice factoring is a financial transaction that involves the selling of invoices to a factoring entity for liquid cash. The receiving company then collects the invoices and is paid by your customers. The factoring company buys your invoice at a lower price, and your company pays the factoring cost.
Types of Invoice Factoring
There are two types of invoice factoring.
- Recourse Factoring;
Under a recourse factoring, the factoring entity sells the invoices and returns any uncollected invoices or those that are unpaid for after some time to the business owner. This type of factoring attracts competitive rates since it’s the business owner who risks.
- Nonrecourse Factoring;
Under a nonrecourse factoring, the factoring entity assumes the risks of unpaid invoices. The business owner can continue with his activities unaffected by the payment of the invoices. As a result, this factoring is very expensive for business owners.
Admissibility of nonrecourse factoring is affected by factors such as the debtor’s credit rating and payment history. Also, nonrecourse factoring mainly applies after a debtor has declared bankruptcy. Otherwise, the factoring entity buys back the invoice.
Evaluation of clients and the value of the invoice should be carried out by the business owner to help them decide which invoice factoring to consider.
Factors to Consider When Choosing a factoring entity
After deciding to use invoice factoring to fill a financial gap, the next step is choosing which company suits your needs. Here are factors that you should consider.
Different factoring companies have penalties that are mainly hidden. Try to understand those penalties like what causes them, their proportion, and if they are fair among other factors. If you find anything unfavorable, don’t sign the contract.
- Avoid Contracts
Due to the profitability of the industry, many factoring companies lock their clients in long-term agreements. While the contracts are good for the factoring organization, they are bad for company owners. Cancellation of any contract attracts huge fines. Avoid signing long-term contracts.
- Customer Privacy and Confidentiality
Many factoring companies like to communicate with your customers once invoices are sold. If you want to maintain the confidentiality of your customers, you should consider companies that allow “non-notification factoring.” This helps you maintain communication control of your customers.
- The Value of the Upfront
An “advance” rate refers to the proportion of the invoice value that the factoring entity is offering you. An advance rate of 70-90% of the price of the invoice is considered fair.
- Spot Factoring
Before deciding on a factoring entity go through its contract clearing. Some companies demand submission of all invoices of a given client. This is called “whole ledge.” Alternatively, there is another plan called “spot factoring” that lets the business owner choose which invoices he wants to advance. Despite the flexibility offered by “spot factoring,” the main disadvantage is that it attracts premium costs.
Always consider the importance of every factor to your business.