If you own a business or you are planning to own one, you should be familiar with invoice factoring. It is a financial transaction and a type of debtor finance using accounts receivables financing.

Here’s what it entails; Business owners sell their invoice to a third party known as the factor. If a company needs urgent cash, it can sell its receivable assets to finance the business.

Invoice factoring is an account receivables financing, business owners can turn their invoice into cash, especially if it is due in 90 days. It is very suitable for small businesses; it helps them raise some money for little expenses.

How Invoice Factoring Works for Small Businesses

As already stated, invoice factoring is a go-to source of income for small businesses owners, if they have an invoice (receivable), that’s due in 90 days. This invoice is sold to a third party for an initial advance of about 85%, and 15% minus fees after the invoice is cleared, other factors like the size of transaction between you and your customer, the nature of your business, and other risk parameters determine the fee you’ll be charged by the third party.

Here’s how the entire process works:

1. Invoice Your Clients

The business owner will transact with his B2B or B2G customer; he will issue out an invoice. If eventually the business owner needs urgent cash and can’t wait for the invoice to be paid, he can get invoice factoring from a third party. The invoice must be payable within 90 days.

2. Sell The Invoice To a Third Party (Factor).

If your invoice is payable within 90 days, the next step is to find a factoring company that suits your need, then do a brief research on their processes. On the other hand, the factoring company will not grant your request automatically; they will, in turn, check if you are eligible to receive financing, they will also research about the customers you are invoicing to see if they have a good credit history.

If the factor finishes his investigation and finds you eligible for invoice factoring, you’ll be made to sign a financing agreement. After the agreement is signed, you’ll sell them your outstanding invoices.

3. Notice of Assignment

Once the invoice has been submitted, and a rate has been agreed, the factor gives the business owner advance rate, usually around 85% of the invoice value.

Once you’ve collected advance, the factor has the liberty to send notice of the assignment to your customer. The essence of sending a notice of assignment is to notify your customer that the invoice you issued to them has been sold to a third party. The factor then sets up a designated account (a lockbox account), where the factored invoices would be paid.

Different type of business has a unique style of factoring, and some are more accustomed than others. For instance, if you are into trucking or shipping, you’ll use freight factoring, there’s staffing and recruiting factoring for recruiting agencies. Some customers are already familiar with how invoice factoring works, but those without prior experience on factoring will need a notice of assignment.

4. Your Client Pays the Factor

Since the invoice guarantees a 90 days repayment span, your client will pay the factor directly within the agreed time; payment would be made into the lockbox account.

The factor will not use offensive techniques when collecting payments, so your relationship with your client will not get sour. The factor generally implores diplomacy even if your client is past due.

5. You Get Your Remaining Balance

Your remaining balance varies based on how much you’ve received an advance and fees charged by the factor.

After the invoice is cleared by your client, you’ll get your balance called reserve amount.

Let’s say the factoring fee is 2%, and you were paid an advance of 85%, if your client repays within 30 days, you’ll be paid 13% of the reserved amount.

Invoice factoring involves you selling your invoice at a discounted price to a third party, for urgent cash. The third party then takes possession of the invoice and gets paid directly from your client; the third party only permits a repayment period of 30 to 90 days.

Let’s say you sell fruits as a wholesaler to a retail business, your retail client agrees to pay off its invoice in 45 days, if you need to settle your payroll in a week, and there’s no available cash, invoice factoring is a great option because other traditional means of getting loans require longer procedures.