The invoice factoring service has a number of advantages and disadvantages. Allowing the company to get cash right away is its main advantage. However, using the services of a factoring company requires the company to spend money to pay fees.
What are the other advantages and disadvantages of invoice factoring? This article will elaborate on that. And, now, assume you are operating a business.
What is invoice factoring?
Invoice factoring is a financing arrangement in which your company sells invoices to finance companies (factoring companies) for cash. The factoring company will verify the invoices to make sure they are valid and then pay, usually around 80-90% of the total invoice value to your company.
Now, you no longer have to charge payments to your customers. They will pay to the factoring company. Your company will get the remaining invoice value after all your customer receivables are collected.
Billing is sometimes successful and sometimes not, giving rise to credit risk. How it is divided between you and the factoring company, it depends on the arrangement, whether with recourse or without recourse.
Invoice factoring is a potential source of short-term financing. When your invoices pile up, your company can take advantage of this service to improve cash flow .
Benefits of invoice factoring
Invoice factoring services are one way to finance short-term cash needs. Your company can immediately get cash without having to wait for customers to pay their bills to you. What are the advantages of invoice factoring? Let’s discuss one by one.
Improve cash flow
Utilizing factoring services can make future cash flows more predictable. Your company can get cash immediately as you plan. It allows you to avoid business failure due to poor cash flow.
On the other hand, collecting payments from customers is not always a success. Some customers may pay on time and that’s not a problem.
However, others may be in arrears and pay later than your company’s credit policy dictates. They can become bad debts and require extensive collection, putting the cash inflows you realize don’t go according to your plans.
Earn cash fast
By selling receivables to a factoring company, you can get cash right away. The factoring company will verify and ensure that the invoice to your customer is valid and transfer the portion of its value to you, usually 80-90%. The factoring company then charges your customer and pays you the balance, about 10-20% less fees, after the customer has paid all the bills.
The cash you receive helps with working capital and covers the funding gap caused by some late paying customers.
Balancing the potential for increased sales and credit risk
Selling products on credit is one way to encourage purchases by customers. But, it also carries risks because your money is tied up with the customer. You can’t use it until your customer pays. Such a situation requires a balance between the potential for increased sales and cash flow risk.
Then, providing a lenient credit policy can be a pull factor and keep your customers loyal and keep buying from you. On the other hand, if your policies are too strict, they can turn to your competitors.
So, by using a factoring service you can, on the one hand, be able to offer a longer payment term and encourage your customers to stay loyal. On the other hand, you can improve cash flow to support your business operations.
Alternative sources of financing
When companies have difficulty accessing funding, such as from loans to banks, for example due to lack of collateral or a poor credit profile, they can use factoring services to get cash. Unlike banks, factoring companies are more interested in the validity and quality of your receivables than your company’s credit profile.
In addition, selling receivables does not make you have to spend money regularly. That’s different from bank loans, which require you to make regular payments – part of the interest and principal – even when your company is not making sales. Likewise, when you issue bonds, you pay regular coupons and pay off principal as they mature.
No collateral needed
Your company can get cash without needing to pledge their assets or property. You simply sell the invoice you have.
It is different from a bank loan. You must pledge assets and may have to forfeit the collateral if you fail to repay the interest and principal on the loan.
Your company can share the risk of uncollectible accounts with the factoring company. For example, under a no recourse factoring arrangement, the factoring company will assume credit risk when receivables fail to be collected or are past due.
However, under a recourse factoring arrangement, your company bears the credit risk. When receivables are uncollectible, the factoring company has the option to sell them to your company. So, your company agrees to be responsible for non-recoverable invoices
Payment and billing automation systems can be useful when customers pay on time. But, when they don’t, you have to catch up and collect payments from them one by one. And collecting payments from bad debts can consume significant resources, more than the fees you pay the factoring company.
Resource consumption is higher when you have a lot of outstanding receivables and especially if they are mostly in the bad debt category. You need more effort and staff from the accounting and finance departments to collect payments. And, oftentimes, such work is stressful.
Disadvantages of invoice factoring
Sometimes, you have a few invoices to collect. The billing system in your company is still working normally to do this. So, you don’t have to use invoice factoring services because you have to spend money to pay fees. In addition, using this service also has a number of drawbacks.
Bad company reputation
When you use a factoring service, the way the factoring company approaches and collects payments from your customerscan affect your reputation. To pursue a bill, they may do so in a impolite or ethical manner, inconsistent with your company’s values. They don’t have the same standard approach you have when communicating with your customers.
So, your company is also indirectly affected. Your customers may prefer to deal with your own company than with a third party. For this reason, choosing the right partner is a must.
Then, customers can also assume you don’t have sufficient resources to collect payments when using third party services instead of billing yourself. That’s because you can’t supervise and control your own credit control.
Not always successful for sale
The factoring company will verify the invoice you sold. They may not approve the financing of all your invoices. It depends on the quality of your invoice and your customer. They will check your customer’s creditworthiness and payment history.
If your customers have poor credit risk, your invoices are less likely to be approved. So, if most of your invoices are of poor quality, you will get less money.
Requires a big commitment
Factoring companies operate to make money. The more they handle invoices, the more potential money they earn. Of course, when doing business with your company, they want to tie you to a long-term contract and take over most of your receivables.
But it may not suit your company’s needs at any given time. For example, in a certain year, you need their services because your bills are piling up or most of them have the potential to become bad debts.
But in other years, such problems did not occur. Your customers pay on time and your bills are relatively small. So, you don’t need their services.
Fees for using a factoring service can be more expensive. The factoring company may charge other fees such as processing fees for each invoice you sell, application fees and credit checks of your customers.
Then, not all businesses use factoring services. Small companies with few customers also usually do not need this service.
Then, when your billing system is still working normally and your resources are available, not using the services of a factoring company can save you money because you don’t have to pay a fee.