Understanding Invoice Factoring and how it Works

Businesses sometimes face financial emergencies whereby the required funds are not readily available and in such cases, it becomes necessary for the management to turn to external sources of funding. Invoice factoring is one of the ways through which a business can obtain much-needed funds.

But how does invoice factoring work? This article will answer the question and help you decide whether it is the best funding option for your business.

How Invoice Factoring Work

Invoice factoring suits businesses that issue invoices after the sale of goods or services. It is a good source of finance for distributors, trucking firms, staffing agencies, wholesalers, and freight brokers among others that transact using invoices.

A business that needs urgent cash approaches a factoring company. The business owner, manager, or any other relevant person then sells and assigns the invoices to the factor. Factoring requires that invoices be payable within 90 days for them to be acceptable.     

Factoring companies usually conduct a background check to ensure that the invoices are valid. The process also seeks to ensure that the goods or services that had been offered by the business are not a risk which can then complicate payments.  

After the factor receives the invoices and confirms their credibility, an agreement is reached with the business. The factoring company then converts the invoices into immediate cash. The worth of the invoices determines the total amount that you can obtain from the factor.

The factoring company then contacts the customers and notifies them of the agreement. It informs them that future payments will be made to the factor as opposed to the business where they had obtained the goods or services. In some instances, the business is responsible for informing the customers that future payments should be directed to the factor

The payment for the invoices is usually made in two installments which mean that you will not receive the full amount on the first day. Typically, you are given about 80% of your invoice in the first installment. You then receive the remaining amount after the customers have paid the invoices in full.

There are costs which may affect the total amount of money that you will receive from the factor. They include discount charge, service charge, transaction fees, minimum usage fee, origination fee, incremental fee, and collection fees among others.

The costs vary with the factor and are usually determined by variables such as the volume and size of the invoice, the industry in which the business functions, customer creditworthiness, invoice payment terms, and the organization’s financial status.

Understanding the costs involved, how they work, and how they will affect the amount that you will receive at the end can help you choose the best factoring company.

To Sum Up

Invoice factoring is an alternative source of finance that gives businesses access to funds. For you to decide whether it is the right source of funding for your business, you should answer the question ‘how does invoice factoring work?’ Understanding how it works will also help you to choose the best factoring company.  

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