Does your business struggle with uneven cash flow? If so, you’ve probably looked into invoice factoring. Whether it’s customers who take forever to pay their bills, difficulties meeting payroll obligations, or missed opportunities to bid on bigger jobs because you lack the cash for supplies, invoice factoring offers a fast, flexible, and low-risk solution – provided you don’t make any common invoice factoring mistakes.
Invoice factoring helps businesses smooth cash flow quickly, letting you expand your business faster. It gives you immediate cash and might even help you build business credit. Understand how it works and what to watch out for before choosing a factoring solution for your business.
What is Invoice Factoring?
With invoice factoring, a factoring company (we’ll refer to it as a factor) buys your accounts receivables. The factor then assumes the responsibility of collecting the money from your customers. And, depending on your contract, you could get about 80% of the value of your accounts receivables right away.
Don’t Make These 15 Invoice Factoring Mistakes
Before signing an invoice factoring contract, keep these 15 common invoice factoring mistakes in mind.
Confusing Invoice Factoring with Invoice Financing
One of the most common invoice factoring mistakes business owners makes involves confusing invoice factoring with invoice financing.
Invoice factoring and invoice financing are similar. They’re both based on borrowing on the strength of a business’ accounts receivables. Yet invoice factoring differs from invoice financing in one important way. With invoice factoring, a factoring company buys your accounts receivables. It then takes over collecting your business’ unpaid invoices.
With invoice financing, your business still takes responsibility for organizing, tracking, and pursuing the collection of unpaid customer accounts.
Confusing Invoice Factoring with Credit Card Factoring
Credit card factoring allows businesses to borrow against their credit card and debit card revenues. Invoice factoring involves borrowing against accounts receivables. A credit card factoring arrangement typically offers lower amounts ranging from $7.5k to $1m, with invoice factoring better suited to amounts in the $50k to $10m range.
Credit card factoring typically comes with lower rates than invoice factoring arrangements. And you could get approved in 1 to 2 days compared to 1 to 2 weeks for invoice factoring.
Not Considering Other Options First
When your business faces a cash flow crisis, you might find yourself panicking. And while invoice factoring could indeed be the right solution for your business at this time, don’t make the mistake of jumping into it before considering other options first.
For example, a business credit line could help you meet payroll obligations and help smooth cash flow. Or a working capital loan could help you manage business expenses. Depending on your business credit and business situation, these could prove better long term cash flow solutions.
Assuming Your Business Won’t Qualify for Invoice Factoring
Does your business have a less-than-perfect credit score? Don’t make the mistake of thinking that means you won’t qualify for this type of financing arrangement. With invoice factoring, the factor considers the credit of the customers on your accounts receivables list. This helps them decide if they have a good chance of collecting. So even if your business has bad credit, considering applying for invoice factoring.
Assuming Your Business Will Qualify
Another of the common invoice factoring mistakes you don’t want to make is assuming that anyone who wants it can get it. Not every business qualifies for factoring – even if you and your business have excellent credit. Factoring approvals depend on the creditworthiness of your customers. The factor wants to know they’ll have a good chance of collecting the money owed (and their fee) before agreeing to an invoice factoring arrangement.
Overlooking The Contract Length
How many months or years must your business commit to handing over your accounts receivables? You should find the answer in your invoice factoring contract. However, one of the common invoice factoring mistakes business owners make is not reading the contract carefully.
An average invoice factoring contract could range from two to three years. Do you really need the service for that long? Maybe not. Contact us today to discuss your options.
Not Understanding The Restrictions
Do all of your outstanding accounts qualify for factoring? Maybe not. Review your contract carefully with an eye to finding any limitations or restrictions. Again, invoice factoring depends on the creditworthiness of your customers. So pay close attention to any details about the credit ratings of your customers.
Overlooking the “Second Payment” Terms
Another of the common invoice factoring mistakes business owners make is thinking that all invoice factoring contracts are the same. However, the rates, fees, and payment arrangements can vary significantly from factor to factor.
Pay close attention to the fine print around the second payment terms in your invoice factoring contract. The first payment you’ll receive occurs almost immediately when you hand over your accounts receivables list. Yet you could receive a second payment once the factor collects from your customer – known as the reserve. However, that depends on whether they collect within the time frame noted in your contract. If they collect after that, they keep all of the money instead of sending you a second payment.
Not Knowing Your Average Payment Cycle
Making the mistake of signing an invoice factoring contract without knowing your average payment cycle (aka average payment period or average collection period) could mean you’ll pay a steep price for immediate access to just a percentage of your accounts receivables.
Your average payment cycle refers to the average time it takes for you to receive payment from your customers. Invoice factoring works best for businesses with longer payment cycles because of the second payment details in your contract.
Let’s say the factor collects on your accounts receivables quickly, say within 30 days. Depending on your contract terms, instead of taking their fee and forwarding the reserves to your business, they could keep the entire amount collected. And if your average payment cycle falls within or close to that 30 days, they’ll often keep the entire amount.
Not Calculating Your Payment Amount Correctly
How much does invoice factoring cost a business? The short answer? It depends.
Generally, a factor could charge a business anywhere from 1 to 4% of the total outstanding accounts receivables. However, watch for the other charges as well. Depending on your invoice factoring contract, you could pay an additional service fee. And you could also pay an additional percentage on the amount forwarded to the factor.
Once you make invoice factoring arrangements, it’s important to understand your role in the business-factor-customer relationship. Micromanaging the relationship between the factor and your customers could cause confusion and delay in collecting the money.
As the business owner, your role is to connect the factor with your customers. So you’ll share your list of accounts payables contacts with your factor. Then the factor contacts the customers to start collecting.
Although you could certainly make an initial call to customers to let them know the factor will reach out to them, avoid continually getting in the middle of communications. Let the factor do the job they agreed to.
Not Tracking Factoring Details Correctly
What kind of business accounting system do you use? A cloud-based accounting program? Or do you depend on a paper-based system?
Whether you prefer the old-school methods or the latest apps and technology when it comes to tracking your business dollars, make sure it can track your factoring details. These include the advances or payments from the factor, the fees, payments, and reserves — the money they collect from your customers after deducting their fees.
Tip: Choose an accounting program that keeps a running total of your factoring fees. This will help you save time and reduce (or avoid) headaches at tax time.
Not Knowing When Profits Start Shrinking Due to Delinquent Receivables
As any businessperson knows, some customers pay early, some pay late, and some pay right on time. Yet when it comes to those late accounts receivables, do you know how much this costs your business?
The longer it takes for a customer to pay, the more your profit shrinks. Knowing when the profits shrink and by how much can help you decide whether it makes good business sense to invest in an invoice factoring arrangement.
Not Having a Goal and a Plan
Financiers who provide invoice factoring services want to know that you have a short- and long-term plan for the money you’ll receive. Looking for invoice factoring without having a defined idea of how you’ll use it to grow your business could have a negative impact on your approval. However, a clear explanation of your plans could help strengthen your invoice factoring application.
What’s your goal for the money you’d get from invoice factoring? And what would shortening your business cycle mean for your business? Plan to answer these questions in writing or in person to support your request for invoice factoring.
Assuming Invoice Factoring is Debt
Don’t make the mistake of thinking that the money you pay your factor counts as a debt for accounting purposes. Invoice factoring was created to help businesses reduce their debt. It provides cash to pay bills (and other debts) promptly and helps to steady cash flow. In fact, according to KPMG’s 2019 Invoice Factoring IFRS 9 update, invoice factoring doesn’t show up on your balance sheet as debt at all.
If you think invoice factoring could suit your business and finance situation, talk to us about your next steps. Read through this list of common mistakes to make sure you understand how factoring works, and your role and responsibilities. The simple fact is that factoring doesn’t solve every business’s cash flow issues. However, in the right situation, it can offer working capital and an opportunity to quickly expand your small business faster.