One of the most difficult aspects of being a small business is getting funding for expansion. A small business will have limited funds, fewer customers, a smaller inventory, and a lower turnover than its bigger counterparts. This all makes it harder for a traditional lender to agree a loan. Invoice factoring is a fantastic way for a smaller business to leverage their existing invoices and gain access to that money, even when their customers have not yet paid.
What is invoice factoring?
Invoice factoring is where a business sells its invoice book to a lender at a discounted rate (set by the lender and based on risk). The lender will then look after the administration of the invoices and ensure payment for a further fee which is based on the complexity of the debtor book. This arrangement allows the business to draw down a set amount each month based on the invoice turnover.
The cost to the business is the discount rate plus the service charge. These are based on the credit worthiness of the customers, the turnover of the business and the number of invoices that will go through the books each month.
Why is invoice factoring good for a small business?
A small business will often find itself in the situation where they have a number of customers that are using products or services that they pay for in the future. In some cases, this may be a monthly fee arrangement or simply a longer-term invoice arrangement. Smaller businesses that sell to larger organisations are especially at risk as larger organisations often operate on 3-month payment terms. Without the capital in the business to tide them over, the smaller business may find themselves in real trouble.
Invoice factoring is a good option for a smaller business for the following reasons:
- Invoice factoring isn’t debt. This means that the criteria for setting up the arrangement is less onerous than traditional lending. This is great for a business that hasn’t yet established a regular turnover. The credit score of the customer is used to decide the overall risk rather than the business credit score.
- Invoice factoring can be much cheaper. A small business can choose the level of factoring that they want to take on, based on the cost of that arrangement. It is usually possible to choose the invoices that will be used as part of the facility and to limit them to those customers that are good regular payers – thus lowering the overall cost. It is also possible to shop around to find the best combination of fees and discount factor to get the best deal.
- Invoice factoring is a flexible source of funds. The business can take advantage of a regular monthly payment. This is even if their customers are not paying their invoices on time. Knowing what their income will be each month gives them the flexibility to plan ahead.
- Invoice factoring is good for your customers. Because the administration of the business invoices is taken on by the lender, the customers will receive a more streamlined approach, with their expectations clearly laid out. This means that the business can then take the time to look after their customers, without worrying about the money side of the transaction.
The risks for small businesses
While the benefits of invoice factoring for a small business are many. It is worth noting that there are some risks to consider.
- You will have less control over the invoicing side of the business, and this may impact on the relationships you have with your customers.
- The cost to the business can be influenced by the credit worthiness of your customers. You have no control over this, and it could mean your monthly fees are increased. This can lead to fluctuations in the cost to the business.
- You will not receive the full value of your invoices, reducing the value of your business.
- You won’t be able to use the invoice book as collateral on any other loan, potentially reducing your options going forward.
- When leaving an invoice factoring agreement, you will need to pay back any advances made on invoices not yet paid. This can mean that it is harder for a small business with limited turnover and may require some planning.
A small business can become a large business with the right investment and planning.
Get in touch with us at Funding Bay for your invoice financing needs.Check out our invoice finance calculator here.
