When it comes to business financing, most owners of small and medium-sized companies are familiar with bank loans and investment capital. These two traditional methods of financing are not within reach of all business owners; for this reason, the rate of failure among small businesses and start-ups in the United States is dispiritingly high.
Many small American companies go out of business not because they are not able to secure initial financing; not being able to meet immediate obligations and paying the bills is a more common reason for business failure. Cash flow shortages are devastating to small and medium-sized companies because they restrict their ability to meet day-to-day operational expenses and also tarnish their business credit.
American business owners tend to go into deeper debt as they try to remedy their cash flow problems. Using credit cards and taking personal loans are two popular, yet very inefficient, methods. Business loans are equally popular, but they are nearly impossible to obtain once a business has dipped into cash flow shortages more than once. One of the most efficient and accessible methods of financing for the purpose of obtaining cash flow relief is through invoice factoring.
How Invoice Factoring Works
In essence, factoring is a financial transaction that consists of obtaining capital through the sale of account receivable items such as invoices. Factoring works in a simple fashion:
- A business owner signs a contract to sell his or her account receivables to a factoring firm
- The business sends a copy of an invoice that may take some time to settle to the factoring firm
- An immediate cash advance is tendered to the business owner
- The factoring firm waits for payment from the business client or customer
The steps above are part of a process that is very flexible and advantageous to business owners looking for immediate capital to solve their cash flow needs.
Differences between Business Loans and Invoice Factoring
Business loans issued by commercial banks are structured in a way that tends to be restrictive to small companies. Banks are generally interested in lending to business operations that have a high credit rating and strong ability to repay through collateral.
Invoice factoring does not place restrictions on companies; in fact, it is in the best interest of a factoring firm to ensure that its clients are actively doing business and billing their clients. Financial firms that provide funding through factoring transactions are interested in purchasing invoices for work already performed.
Business loans typically involve a contract between two parties: the bank and the business owner. The burden to repay is on the business owner as a borrower while the risk falls on the bank as the lender. With invoice factoring transactions, the risk is mostly absorbed by the factoring firm while the business owner is mostly unburdened.
Banks evaluate business borrowers based on their credit rating, history and collateral. Factoring firms perform audits on the billing methods used by their clients; they may also look into the credit worthiness of the customers and clients being invoiced, but this research is mostly focused on how fast they usually settle invoices.
Whereas business loans typically require a lengthy application and approval process, factoring firms tend to handle their affairs in a more expedient fashion. The audit and approval process takes just a few days, and advancing cash payments for purchased invoices can take as little as 24 hours in some cases. Financial firms that provide factoring are very interested in marketing their services as being faster and more efficient than banks, and they are very diligent in this sense.
One of the most important advantages of factoring is that it is a very seamless process. Clients being invoiced barely notice when factoring firms are involved. Also, unlike a business loan, invoice factoring never shows in a company’s balance sheet.