Factoring involves using your accounts receivable as collateral for a short-term loan. Factoring an invoice can seem straightforward: You provide your invoices to a factoring services provider who gives you a specified percentage for the total of your outstanding debt. You get the cash almost right away, and you settle the debt with the factoring company when your customers pays the factoring company. However, you should understand the terms and conditions of your factoring contract along with the fees involved when you submit invoices for consideration. Discover six of the most common mistakes business owners make when factoring an invoice.
Forgetting to Read the Fine Print of the Contract
Fine print refers to the terms and conditions printed at the bottom of a factoring agreement. You’ll find information on fees, penalties, and terms for repaying the money you are borrowing. Make sure you read this material carefully and understand these terms and conditions when you factor an invoice. If you aren’t completely sure you understand, ask questions before you sign the contract to avoid complications later. You should undertake this type of financing with a full understanding of the expectations you must fulfill while the contract is active.
Ignoring the Factoring Fees
Factoring companies charge a fee instead of an interest rate and the fee is dependent on the time the borrowed funds are outstanding. Most factoring companies charge a small amount of fees on the outstanding balance that ranges from 1 to 3 percent per month on the face value of the invoice. You should account for these fees when factoring to make sure that fees don’t eat up all of your gross margin.
Misunderstanding the Upfront Advance Percentage
Factoring companies don’t work like a bank, nor do they fund like a bank. Borrowing money from the bank means you get 100 percent of the money you request, but you have to pay this money back over time and with added interest. In contrast, the process of factoring pays you a percentage of the outstanding balance of your invoices up front. You won’t get the entire amount owed, but you’ll get most of it.
Here’s an example: You have an invoice of $1,000 that a customer owes you. The factoring company will give you 80% of the invoice amount upfront. The 80% is your advance rate. The factoring company funds you $800 up front and when your customer pays 100% of the invoice, the factoring company will give the remaining 20%, or $200 in this case. The actual advance percentage depends on the credit quality of your customers. Advance percentages usually range between 70 to 90 percent
The advantage here is that you get funded within hours or days instead of waiting at least a week for an answer. A bank may take a longer amount of time to get the underwriting of your loan completed. While a factoring company will investigate the credit quality of your customers, it views the outstanding balance as guarantee of eventual repayment. In turn, you reduce the paperwork requirements and slower pace of approval that comes from financing with a bank.
Not Paying Careful Attention to the Factoring Application
The application for invoice factoring is much shorter than an application for a bank loan. An applicant can make the mistake of putting too much emphasis on information that’s not required for factoring. Read through the application first to learn what information is required and supply all the necessary information. Communicate with your factoring agent when you have questions about the information contained in the application. You don’t want to have your application process slowed down because of a mistake.
The invoice factoring agent is more interested in your relationships with your customers than your credit score. Make sure to only factor invoices from customers who normally pay on time. Customers who are habitually tardy can cost you more money in fees and more time in aggravation due to their lack of prompt payment. You will be held responsible for invoices from customers who don’t pay you on time.
Not Realizing the Invoice Requirements
Make sure to learn about the expectations of the factoring company regarding invoices. That is, the factoring agent may want all the outstanding invoices from one customer, not simply one or two. If you have 10 outstanding invoices from one customer, the factoring services provider may expect you to factor all of the invoices at the same time. This requirement is partly due to the need for consistency when the customer pays the invoices.
Not all factoring companies expect or want you to submit every open invoice from the customer to get financing. Ask before submitting an application to find out if factoring one or two invoices is acceptable.
Failing to Make Repayments to the Factoring Company
Factoring companies usually require an assignment of your payments and will have your customers to make payment directly to the factor’s lockbox or bank account. Make sure you have clarified with the customer how repayment will occur to avoid problems when the money comes due. In essence, the factoring services provider will act like an extension of your company and will not do anything to jeopardize your relationships with your customers.
The above six most common mistakes that business owners make when factoring invoices are ones you should avoid so that you can get the most out of factoring which in turn will help you grow your company through consistent cash flow. Contact FSW Funding today to learn more about how invoice factoring works and how this type of lending can help your business through an income shortfall.