Invoice factoring can be a great option for many businesses, but it does come with some risks and downsides.
In an uncertain economic environment in which costs are rising and margins are narrowing, it is perhaps unsurprising that demand is growing for invoice financing and factoring services. Grandview Research ranks the global factoring market at $3,393.90 in 2021 and predicts the market to grow at 8.8% year on year between now and 2030.
In many cases these can be a lifeline, but any loan comes with risks and it’s important to understand them before signing an agreement.
What is invoice factoring?
With invoice factoring, you essentially sell some or all of your invoices to a third party who then assumes control for chasing them up. Once they have secured payment from your customer, they will subtract the loan amount and their fee before returning the outstanding balance to you.
It’s often used as a way to overcome cashflow issues caused by late or delayed payments and can be particularly useful for those companies who regularly work on lengthy permanent terms of one, two, three or even more months. At a time when thousands of businesses are struggling to make ends meet due to late payments, invoice factoring can be a lifeline during a cashflow crisis. You might also use it to unlock part of the capital within your business to fund expansion or another project.
What are the risks?
The big benefits of invoice factoring are that they unlock money which is locked up in your unpaid invoices. Late payment is a major cause of frustration for many businesses. Knowing the money has been earned but is not yet accessible can cause stress and hold your business back from making key strategic investments. Unlocking that capital can alleviate many cash flow pressures and allow you to spend money on growing your business.
Although you will pay out some money in the form of fees, the ability to hand over the work involved with chasing late payers up can save time, money and free you up to concentrate on other areas of business operations. With those benefits, though, come downsides and risks. Here are a few of them.
The most obvious is cost. Expenses will vary depending on your choice of provider, the deal and the credit history of your customers, but you will miss out on a portion of each invoice. If you use a factoring company for all invoices, this will leave a sizeable hole in your overall revenues at the end of the year. Although you may cover up short term funding gaps, you may become vulnerable to longer term liabilities.
When you hand over invoices to a factoring company, you surrender a large portion of control in your business. They will take on responsibility for chasing your invoices, but they may also stop you from working with certain customers if they have a poor track record of paying their invoices. This can limit your scope as a business and may cause difficulties in acquiring new customers.
Using an invoice factoring company also means you can no longer use your debtor book as security which will limit your options for securing other forms of credit.
Building effective customer relationships is essential for any small and growing business. The best way to do that is to engage directly with them, but by definition using a factoring company puts a layer of separation between you and them. It can erode customer loyalty which is so important in generating repeat custom.
Moreover, some companies worry about the stigma associated with using an invoice factoring company. It implies your cash flow is not as stable as it might be and may consciously or sub consciously reduce your customers’ confidence in your services.
Liabilities of the loan
Last but very definitely not least, there is the possibility that your invoices will not be paid at all. How much of an issue this is depends on your arrangement with the invoice factoring company. Some agree to take on the risk. If they do, they may demand higher fees or have stricter lending requirements which may further limit those companies you can work with.
Alternatively, they may put the risk on you. If the customer fails to pay, you remain liable for the money. This means you’ll have to repay the loan amount plus any fees to the invoice factoring, leaving you even more out of pocket than you would have been.
Invoice factoring, as with any loan product, involves some risks and downsides. In general, though, as long as you choose a reputable provider, it is a relatively safe form of financing, if more expensive than conventional loans. As long as you enter the deal with your eyes open, have made a full accounting of the finances involved and weigh alternative options, this can be a useful service which reduces your exposure to non-payment risks.
If you are looking for safe invoice factoring, get in touch with one of our professionals at Funding Bay.