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Invoice Factoring 101: Turning Unpaid Invoices into Cash

Invoice factoring is the practice of a business selling an invoice to another company for a discount. The third party that purchases the debt is called a “factor.” The company selling the debt will factor receivable assets to meet an immediate cash need or manage credit risk. A more accurate term used for this process is “accounts receivable financing” because it is asset-based lending, or ABL. ABL works in a way that enables you to turn your unpaid invoices into cash for your business.

How Invoice Factoring Works

Outstanding invoices are sold to a factor that pays a lump sum to the wholesaler. The money the wholesaler receives can be used immediately as working capital for things like meeting payroll or financing company growth. This practice is particularly useful when the wholesaler has invoices that are 30 to 90 days net, or even longer, and cash is required quickly.

When the wholesaler receives an order for goods, they first check with their factor for credit approval. The factor will not loan money against just any invoices, though. Only those approved beforehand by measuring the invoice’s credit risk. If approved and once the goods are shipped, the invoice will note that it is payable directly to the factor instead of the wholesaler.

The factoring company verifies the validity of the invoice. Once confirmed, the factor increases the wholesalers line of credit by the agreed upon rate, typically 80%-90% of the invoice value, minus credit insurance and fees. The factoring company then collects the invoice balance from the customer. The customer will pay the invoice balance directly to the factoring company instead of the wholesaler. The factoring company then returns the paid balance to the business that factored the invoice.

For example, this scenario might take place:

A wholesaler has an order from Company A for $200,000. Before shipping, the wholesaler calls the factor or goes online to the factor’s portal and asks if they can ship the $200,000 in goods to Company A next week. Once approved, the factor issues an approval number. At this point, the factor is responsible for the invoice’s credit risk and insurance. Once the goods are shipped, the wholesaler assigns it to the factor. The factor is then responsible for collecting Company A’s payments on said invoice.

If A company’s payment terms are 60 days, the factor will lend the wholesaler 80%-90% of the $200,000 until Company A pays. This way, the wholesaler doesn’t have to wait for 60 days to receive payment.

3 Aspects of Invoice Factoring

When a wholesaler looks to asset-based lending, or ABL, there are several aspects to consider:

Credit insurance

Credit insurance coverage protects the factor from the non-payment of commercial debt. The factor charges you insurance that covers the specific receivable. Credit insurance cost is a straight percentage, but lenders may charge overages if they deem a particular customer to be a higher risk. They may agree to insure this invoice, but you will have to pay a higher rate.

Collections

The factor’s core service to provide cash flow to clients who want to reduce the wait time for cash flow. The factor will handle collecting your invoice payments. When the invoice is paid, you will receive the invoice’s full amount, minus deducted fees and previous loans. The collection fee is a straight percentage.

Borrowing against invoices (ABL or asset-based lending)

The costs of borrowing against invoices are similar to any other traditional asset based loan. The interest rate is pegged to some percentage above a rate benchmark like the prime rate.

Using a factor for a combination or all three

A wholesaler can utilize a factor for one of the three aspects above, or any combination of them. The factor will charge you depending on which services it provides. In addition, some factors will lend against some purchase orders or even your inventory as assets.

What to Watch Out For

When a wholesaler looks to asset-based lending for their invoice factoring, there are several things to watch out for.

Get and track credit approvals

You want to make sure you get and track credit approvals before you ship. If you don’t do so, the factor may refuse to insure the invoice.

At the end of the day, you want to get credit approval before you ship. It only takes a few hours to obtain factor approval. If you’re pressed for time with a shipment, you can call the factor to say it’s a rush and sometimes your factor will provide immediate approval. Most of the time, you’ll know well in advance if an order is shipping.

Per invoice minimum fees

In a factor’s contract, there’s often fine print detailing per-invoice minimum fees. For simplicity’s sake, let’s say, the factor charges 1% for insurance and collection with a $5 minimum per invoice. That means that you will be paying more than 1% on invoices that are less than $500. Most wholesalers may think that that they rarely ship invoices that are less than $500, but if they are doing EDI business and packing for individual stores, or doing replenishment business, they may be in for a surprise.

For example:

You may have a shipment to Company B for $10,000, but this retailer orders three pieces each shipped to 900 stores. As a result, there are 900 invoices for items of very low value. Instead of 1%, the minimum fee it can end up adding up to 4%-5%. Because of these small dollar-amount invoices, the minimum fees can add up.

High-risk accounts

Your factoring company will want to verify your customers with outstanding invoices that have a good payment history.

If Company C is in financial risk, they are put on a credit risk list. In some instances your previous approvals may be revoked. In other cases they may apply surcharges to their rates. Be careful to keep these costs in mind when negotiating prices with these high risk accounts. You may be able to ship to them anyway, but the fees can be steep. In addition, your factor may limit the amount of risk they’re prepared to take with these accounts, so step up your collection efforts to keep balances below the maximums.

Vendor Chargebacks

Vendor chargebacks get moved to client risk.

A vendor chargeback is made when the retailer determines that there was an issue with an order, like items with missing labels or ticketing or part or all of the order missing.

In any case, they inform the factor that they’re going to charge the wholesaler back. The factor doesn’t fight the chargeback, but instead stops collecting the payments and sends it back to you. It’s your responsibility to start collecting on the balance of the invoice. Keep track of this in a separate non-factored aging book.

Concurrent Accounts Receivables Book

You should always keep concurrent accounts receivable books. Here’s why:

For example, a retailer may say they never received an order. You have a limited amount of time to provide the order’s proof of delivery from your AR books, otherwise, the factor will remove the invoice from their books and it becomes your responsibility to collect the invoice (client risk). The invoice will be removed from the factor’s aging and can easily fall through the cracks if you don’t have the proper procedures in place Make it a point to not rely on the factor’s books alone, but keep your own aging to compare against the factor’s.

In addition, be sure to perform a monthly factor reconciliation to compare your books with the factor’s books, so invoices don’t fall between the cracks.

Final Thoughts

Asset-based lending can prove to be a successful way to infuse working capital into your wholesale business. Through invoice factoring, you have the means to work with a process beyond the traditional lending practices. With the aspects featured here, you should be able to turn your unpaid invoices into cash.

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Our team has in-depth industry knowledge and a network of solution providers that help wholesalers make smarter business decisions to scale their business. If you’d like to get free advice and recommendations on invoice factoring and more, feel free to book a time to speak 1-on-1 with one of our knowledgeable industry advisors.

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