How to Use Invoice Factoring to Improve Your Small Business Cash Flow

How Invoice Factoring Improves Your Small Business Cash Flow

Cash flow is a common struggle among small businesses; 82% of failed businesses cite cash flow problems as a significant contributor, while a global study reveals that 61% of small businesses battle to maintain cash flow.

However, there is a lifeline: invoice factoring. Invoice factoring can turn your unpaid invoices into immediate cash, offering a practical solution to keep your business afloat.

What Is Invoice Factoring?

Invoice factoring is a financial strategy tailored for businesses that issue invoices and await payment from customers. Rather than waiting weeks or months for these payments, you can sell your outstanding invoices to a third-party factoring firm at a discount.

The Different Types of Invoice Factoring

  • Recourse Factoring. In recourse factoring, your business remains responsible for any invoices on which the factoring company can’t collect payment. If your customer doesn’t pay the invoice, you’ll need to buy it back from the factoring company or replace it with another invoice of equal value.
  • Non-Recourse Factoring. Unlike recourse factoring, in non-recourse factoring, the factoring company takes on the risk of non-payment by your customers. This means you’re not responsible for buying back unpaid invoices. However, this added security for the business typically comes at a higher cost.
  • Spot Factoring. Also known as single invoice factoring, spot factoring allows your business to factor in just one invoice at a time. This offers greater flexibility but often comes with higher fees due to the one-off nature of the transaction.
  • Whole Ledger Factoring. In this arrangement, your business agrees to factor all of its invoices with the factoring company, providing a more consistent cash flow. Fees for this service are generally lower since the factoring company gains a broader overview of your accounts receivable, thereby diluting the risk.
  • Reverse Factoring. Also known as “supply chain finance,” in reverse factoring, your business arranges for a finance company to pay its suppliers on its behalf. You then repay the finance company later.
  • Export Factoring. Designed for companies that do business internationally, export factoring involves a factoring company handling collections on foreign accounts receivable. This often includes services like currency exchange and credit checks on foreign customers, providing a holistic solution for international trade.

The Cost of Invoice Factoring

Factoring fees are the primary cost associated with invoice factoring. Factoring fees are typically a percentage of the invoice’s face value and can range anywhere from 1% to 5% depending on various factors like the quality of your invoices and the length of the payment term. The factoring company deducts this fee before disbursing the advance.

At Merchant Factors, we charge an administration fee and an interest rate – agreed upon upfront with your business:

  • The interest rate ranges from between 2.0% and 3.0% above the prime lending rate on funds that have been advanced until the invoice is settled by your customers.
  • The administrative fee ranges from 0.5% to 2.5%.

How invoice factoring works

How Does Invoice Factoring Actually Work?

Invoice factoring is designed for businesses needing quick cash access to maintain operational fluidity, pay suppliers, and meet payroll requirements. The process is straightforward, providing immediate relief to your cash flow concerns:

  • Invoice Your Customer. As usual, you issue an invoice to your customer for goods or services rendered.
  • Sell the Invoice. You sell the invoice to a factoring company instead of waiting for the customer to pay.
  • Immediate Payment. The factoring company pays you a significant percentage of the invoice’s value as close to the same business day as possible.
  • Debt Collection. The factoring company assumes the role of your debtor’s department and collects the full invoice amount from your customer based on the agreed-upon payment terms.
  • Receive the Balance. Once the customer pays the invoice, the factoring company sends you the remaining invoice balance minus a predetermined fee for their service.

Is Invoice Factoring Right for You?

If you frequently face delays in customer payments but have immediate expenses like payroll and supplier bills, invoice factoring can offer quick relief without the extended approval periods associated with traditional loans.

Businesses that deal primarily in B2B (business-to-business) or B2G (business-to-government) transactions and have a high volume of invoiced sales are usually better suited for invoice factoring.

Ask yourself the following questions:

  1. How Creditworthy Are Your Customers? Factoring companies primarily focus on the creditworthiness of their customers; do your customers have a strong track record of timely payments?
  2. What Level of Flexibility Do You Require? Invoice factoring can range from single-invoice options to whole-ledger solutions. Which type of factoring flexibility best suits your business needs?
  3. What is Your Cost Tolerance? Invoice factoring comes with a fee. Are the benefits worth the cost, and can your business sustain these fees over time?
  4. Does Invoice Factoring Align with Your Long-term Business Strategy? While invoice factoring can solve short-term cash flow problems, does it fit into your larger, long-term business and financial strategy?
  5. Are You Willing to Outsource Collections? Invoice factoring often involves a third-party company managing your debt collections. Are you comfortable with an external entity interacting with your customers to collect payments?

How Invoice Factoring Can Boost Your Cash Flow

Invoice factoring allows you to convert your outstanding invoices into liquid assets, often within the same business day. Invoice factoring can benefit your cash flow in the following ways:

  • Predictability allows you to improve planning and budgeting.
  • Reduce debt and interest costs.
  • Seamless inventory restocks and supply chain investment. 
  • Greater employee retention and recruitment.
  • Effortlessly tackle seasonal cash flow fluctuations. 
  • Leverage new business opportunities.

Tips for a Smooth Invoice Factoring Experience

Before diving into an agreement, assess your cash flow needs, the volume of invoices you’re looking to factor in, and how often you anticipate needing this service. This helps you select the right factoring option and negotiate terms more effectively.

  • Since the cost of factoring often depends on the creditworthiness of your customers, vet them carefully. High-quality receivables will likely result in better terms and lower fees.
  • The more organised and accurate your invoicing and accounting practices are, the easier and more cost-effective the factoring process will be.
  • Regularly assess the impact of invoice factoring on your cash flow and overall business performance. This will help you decide whether to continue, modify, or terminate the service based on its effectiveness.

How to Choose the Best Invoice Factoring Company for Your Small Business

Start by pinpointing exactly what you need from a factoring company – be it quick funding, low fees, or specialised services related to your industry. Knowing your specific needs will help you narrow down your options.

  • Check reviews, ratings, and testimonials for any company you’re considering. Personal recommendations from business contacts in your industry can also be invaluable.
  • Verify Industry Expertise. Ensure the company you choose understands the nuances and challenges of your specific industry.
  • Check Creditworthiness and Reputation. A factoring company will handle your customer invoices, so it is essential to ensure they’re financially stable and reputable. Check their credit rating, if available, and look for any red flags like legal disputes or complaints.
  • Understand the Terms Clearly. Ensure you fully understand the terms of the invoice factoring contract, including fees, the length of the contract, minimum volume commitments, and termination clauses.
  • Examine the Fee Structure. Factoring companies have different ways of structuring their fees. Some might offer a flat fee, while others may charge various additional fees for services like wire transfers or overdue payments.
  • Ask About the Collection Process. Since the factoring company will often be responsible for collecting payments, it’s essential to understand their process and ensure it aligns with your business’s standards.
  • Check if the factoring company can adapt to your growing needs. Some companies offer scalable solutions that can grow along with their business, providing more significant benefits in the long run.
  • Speed of Service. If quick access to cash is your primary need, find out how fast the company can process your invoices and transfer funds. Time can be of the essence when taking advantage of business opportunities or meeting operational costs.

At Merchant Factors, we’re dedicated to empowering South African SMEs to stabilise and improve their cash flow. This service has helped businesses like yours to scale successfully in a challenging economic environment.

“Being able to keep up with the short-term cash flow demands, and freeing up capital for development, allowed us to expand our offerings and reach a new array of customers. We are on track to double our annual turnover. Thank you, Merchant Factors.” – Director of Copper Cables and Connectors.

Contact Merchant Factors today to improve your cash flow with invoice factoring.