What is invoice factoring?
Let’s say you’re an enterprising young entrepreneur, and you’ve decided you’re going to make your next million selling widgets. Excited and hopeful, you approach a manufacturer.
Excellent! You pay the $100 and get 10 widgets to sell. And don’t worry, you’ll be charging $20 per widget, so you’ll make that money back in no time!
You set up a digital storefront on Amazon, you implement a top-notch marketing campaign, and before long, you have clients clamoring for your widgets!
But alas, you soon run into a slight hiccup.
You have provided your customers the widgets that they requested, but you have to wait 30 days to receive your money. In accounting, this is referred to as an account receivable (A.R.). This is not an ideal situation for any merchant, since it limits your ability to restock and cover business costs.
You could wait 30 days, but there’s got to be a better way, right?
The basics of invoice factoring
Accounts receivable are considered assets, and as such, there is a market for them. Invoice factoring is when you, the merchant, sell your account receivable to a factoring company in exchange for cash at a discount.
The factoring company first takes a fee for the service provided. This fee is referred to as a factoring fee or discount rate. In this example, the fee is 3% of the account receivable, or $6. That means that you, the merchant, will be receiving 97% of the value of the account receivable, or $194.
It is important to note, however, that you won’t receive it all at once. 85% of the remaining invoice value will be paid to you as an initial advance. In this example, you will receive $165 (85% of $194).
Once the invoice is collected, you will receive the other 12% ($29, in this case). This two-installment program gives the factoring company more security, since they have assumed the risk of the client not paying.
Speaking of clients not paying, there are two types of factors: recourse and non-recourse. These contracts address your responsibility as a merchant if your invoices go unpaid. A recourse factor will require you to either buy back the invoice from the factoring company or replace it with one of equal value. A non-recourse factor does not hold you liable for repayment, but may lead to higher discount rates in the future.
Is it the right choice?
When done right, invoice factoring is a powerful tool, providing working capital and eliminating cash shortfalls. It can help you turn your business into a well-oiled machine that runs like this:
In the above diagram, everyone’s happy. You’re selling widgets and are well on your way to your first million. The factoring company is making money by helping you convert your accounts receivable into usable cash. The manufacturer has steady demand for his products. Your clients are getting their much-desired widgets. And Jeff Bezos is probably off somewhere giggling to himself.
You may be asking, “Sounds great, but how sustainable is it?” And our answer is: “It depends on two things – your clients and the company you choose.”
Financial institutions want to be paid back, so they will likely be running credit checks on your clients. If your clients have bad credit, this model is not going to be sustainable. Best case scenario, you will still have a higher discount rate due to higher risk. If the factoring company can’t collect, you might get stuck footing someone else’s bill. If your clients’ credit scores are too low, you may not even qualify for invoice factoring.
When you sell your invoice to a factoring company, you are also giving them control over collection. They may try to do this themselves, or they may assign that responsibility to a collection agency. Either way, you are no longer in control of the situation, and as a result, your clients may have a bad experience. And everyone knows unhappy clients are bad for business!
Hidden costs, such as application and processing fees, can erode invoice factoring’s sustainability. Depending on your clients, you may also have to pay credit check fees and late fees. As a business owner, it is important for you to understand all of the costs and know exactly how much you will receive.
In our widget example, you would be making $0.97 for every dollar owed ($194 cash / $200 A.R.). Put another way, you would be paying $0.20 per day for that service ($6 discount fee / 30 days). You can use these numbers to perform a cost-benefit analysis, and from there, you can make an informed decision about whether the time-money payoff meets your needs.
Ready to get started?
Here’s why we think Aldora is a great fit for your company’s invoice factoring needs:
- We get to know you. We want to make this a win-win, so we take the time to research your business and determine your profitability. We use this to set a maximum discount rate, meaning that we never charge you in a way that won’t be profitable for you.
- We're straight talkers. No hidden fees, no fine print. Our specialists tell you about each and every fee before you sign a contract. Aldora hires analysts, not lawyers. We think our time is better spent cutting costs, not sneaking fine print into our contracts.
- We're flexible. We fund in one-month increments, which gives you flexibility and allows for better budget forecasting. We are comfortable working with businesses that are only a few months old, so long as you have invoices from a reputable source. As our relationship and trust grows, you will eligible for more and more funding.
To learn more about the application process, please submit a written inquiry here or call us at (458) 888-8042.
To begin the application process, please click here.
Note: The figures used in this article are intended for demonstration purposes only. Costs and fees differ from client to client. Please contact one of our specialists if you would like to receive a tailored estimate.