Invoice factoring, sometimes called debt factoring, is a type of business funding that provides instant payment on B2B invoices. Unlike loans or lines of credit, your business has no debt to pay back because your client clears the balance when they pay their invoice. This also means that the credit of your client, also known as your debtor, is a crucial component in the factoring approval process. We’ll walk you through what this means and the qualification process below.
Understanding the Pros and Cons of Debt Factoring for Business Financing
Debt factoring, often termed invoice factoring, is an increasingly popular business financing option, especially among small businesses. It involves selling your invoices to a factoring company, which then assumes the responsibility of collecting payments from your customers. This method of receivable financing offers a unique advantage for businesses in need of working capital without incurring debt like a traditional business loan.
One of the main advantages of debt factoring is the immediate boost it provides to your cash flow. By transferring your outstanding invoices to a factoring company, your business can get paid a significant percentage of the total invoice amount upfront. This is particularly beneficial for newer companies or those with cash flow constraints. However, it’s essential to consider the cost of factoring, which includes a factoring fee and, in some cases, the risk of bad debt if opting for non-recourse factoring.
On the flip side, the disadvantages of debt factoring can include a potential impact on customer relationships and the factoring company’s control over which invoices are eligible. If your business has customers with bad credit or unpaid invoices, they might be deemed too high of a credit risk, limiting the invoices you can factor. Additionally, for small business owners, the decision to use invoice factoring should align with broader business goals and financing needs, as the terms and conditions can vary from company to company.
In summary, while debt factoring offers a practical solution for immediate cash flow needs and avoids the need for a traditional line of credit, it’s crucial for business owners to weigh the advantages and disadvantages. Factoring can offer short-term financing relief, but finding the right factoring company that aligns with your business’s unique needs and creditworthiness is essential.
How to Get Approved for Factoring
When you factor invoices, you’re selling them to a third party, known as a factor or factoring company. The factor immediately advances you most of the invoice’s value, then waits for your client to pay. You receive the remaining sum minus a small factoring fee when the client pays. Most small businesses qualify because the burden of repayment rests largely on the client with the outstanding invoice. The requirements are different than what you’ll experience with other forms of funding, too.
Typical Factoring Requirements
Before you can begin factoring invoices, your factoring company will look into six key areas.
1. Debtor Creditworthiness
In this stage, the factor evaluates your client’s creditworthiness. They’ll likely pull a credit report from a third-party credit reporting bureau such as Dunn & Bradstreet and obtain an accounts receivable aging report from the debtor. Using these documents, and perhaps others, the factor will then determine how much, if any, credit the factor is willing to extend to the debtor. It’s worth noting that the factor does not tell you whether you can work with the client or invoice them for services. The factor has no control over your relationship with them. The factor can only decide whether it’s willing to factor their invoices and what the limit will be. You can always choose to work with a client that the factor does not deem creditworthy, but those invoices will not be accepted for factoring. Generally speaking, however, it’s in your best interest to limit trade credit to the extent your factor does, as extending credit beyond this exposes your business to unnecessary risks.
2. Terms of Sale and Invoice Collectability
The factor will also examine the terms of sale to ensure that the goods or services have already been delivered and accepted by the debtor. Typically, only straight sales will be accepted. This means the debtor has no right to withhold payment or return merchandise. If you work with guaranteed, consignment, bill and hold, or billing in advance sales, factors will generally not accept the invoices for factoring. Additionally, the factor will consider the net payment terms as they relate to the industry. This typically ranges from net 30 to net 90 terms, though factors sometimes make exceptions. Extended terms are more likely to be considered when the factor specializes in your industry and understands why an exception should be made based on its experience.
3. Competing Security Interests
The factor will expect priority position on all receivables being factored. If a bank or other entity is already leveraging those receivables as collateral or there is a lien in place, the other entity would have to give the factor first position before moving forward. For instance, the IRS may place a lien on all assets if your business has unpaid taxes. However, the agency is interested in accelerating repayment. If you can make the case to the IRS that you’ll be able to repay them quicker by leveraging invoice factoring, it may take second position. If your invoices already serve as collateral on a loan, however, it may be more challenging to convince the lender to take a subordinate position.
4. Invoice Verification
The factor will then confirm that the invoice is valid. This may be done by leveraging one or more of the following methods:
- Reviewing documents
- Verbal verification with the debtor’s accounts payables department
- A signed guarantee by the debtor
Bear in mind that most large companies have experience working with factoring companies and will not find these steps unusual. Some will even appreciate that addressing these steps allows them more time to pay their invoices than your business can provide on your own, which boosts customer satisfaction.
5. Concentration
Concentration refers to the amount of credit being extended to a specific debtor compared to the overall amount of credit being extended. Generally speaking, factors prefer to keep any debtor’s concentration under 20 percent to minimize risk.
6. Compatibility
Lastly, a factor will consider how compatible your needs are with what they can provide. For instance, they’re likely to consider your industry and are more likely to work with you if you’re in one of their specialty areas. They may also examine your average transaction size or overall volume needs.
FAQ About Factoring Credit Checks and Debtor Credit
Now that we’ve covered the background on getting approved for factoring and why client credit checks matter, let’s review some commonly asked questions about the process.
Will Factoring Companies Perform Credit Checks on New Clients?
Yes, debtor credit will be checked anytime you wish to start factoring invoices for a specific client.
Do Factors Only Reject Non-Creditworthy Debtors or All Invoices?
If you have a mix of non-creditworthy debtors and creditworthy debtors, you can still factor invoices for those that are creditworthy.
What Happens If Your Clients Don’t Pay?
There are two main forms of invoice factoring: recourse and non-recourse.
- Recourse Factoring: Your business must repay the advance or provide invoices of equal value to cover the debt, depending on the terms of your agreement.
- Non-Recourse Factoring: The factoring company assumes the risk of non-payment, and your business owes nothing if the client doesn’t pay.
Most factoring companies and businesses opt for recourse factoring because credit checks do a fair job of minimizing risk already. Non-recourse also tends to be more expensive for the business.
What Can You Do if Your Factoring Application Gets Rejected?
First, find out the reason for your rejected factoring application. Sometimes, applications are rejected because information is missing or unclear. If this was the case in your situation, you may be able to supply any missing information and have the application reprocessed. Some businesses and debtors simply aren’t a good fit for invoice factoring. If this is the case for you, talk with your factor to find out if they offer additional funding solutions that might be a better fit.
Get a Free Factoring Rate Quote
Specializing in a wide variety of industries with decades of experience, Viva Capital is happy to walk you through the process and help you find the right funding for your needs. To get started, request a complimentary factoring quote.
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