In an era where small businesses are cropping up in every corner of the country, having financial assistance is becoming the need of the hour. Many entrepreneurs dream of turning their ideas into solutions for the masses, however, only a few of them succeed. One reason behind the slow growth trajectory of many small businesses is financial insufficiency. To help entrepreneurs and small business owners expand their services, various banks, financial institutions, and non-banking financial companies (NBFCs) are offering financial products such as Working Capital Loans, Small Business Loans, MSME Loans, and others.
However, business owners can also consider invoice factoring, which is slightly different from Small Business Loans to meet their short term funding requirements. Let us understand what invoice factoring in small business financing is in this blog.
Invoice factoring is a type of small business financing instrument that is different from loans. In short, invoice factoring is when you sell your outstanding invoices from customers to a factoring company, also known as a factor, at a discount. In exchange for these invoices, you receive funds immediately from the factor, instead of waiting for your customers to pay you.
This type of financing is popular among Business-to-Business (B2B) and service-based small businesses that have their funds blocked in outstanding invoices. Invoice factoring can be leveraged to fix cash flows in businesses, especially for those that are relying on seasonal sales.
Unlike term loans where you receive lump sum funds that you pay back with interest, with invoice factoring, you sell your outstanding invoices to a factoring company in exchange for advance capital. A factoring company can lend you funds up to a discounted percentage worth of your invoices say 90%. After a factoring company verifies your invoices, the funds are disbursed to your account, and the factoring company will take charge of collecting the outstanding invoices.
Invoice factoring companies also charge a small fee (1-2%) of the total value of the invoice for each week the customer takes to pay back. This fee is also known as the factor rate. Once the customers pay back, the factoring company will give the remaining percentage of funds, excluding the fees.
Suppose there is invoice worth Rs. 5 Lakh. Factoring company agree to finance 80% of invoice upfront. In this case, business will receive Rs. 4 Lakh, and the remaining Rs. 1 Lakh will be kept by the company.
The company will charge a 1% fee on total value of invoices. Let’s assume the customer takes 3 weeks to pay the outstanding bill. Here, the company will charge a 3% factor rate or factor fees, which means borrower be charged Rs. 15,000 by the factoring company. Out of the Rs. 1 Lakh, the factoring company was holding, borrower will only receive Rs. 85,000 back. In total, borrower will receive Rs. 4.85 Lakh for a Rs. 5 Lakh invoice.
Invoice factoring and invoice financing are used interchangeably quite often. However, there are some differences between the two.
In invoice factoring, the company ‘purchases’ borrower invoices at a discounted price. In the case of invoice financing, borrower can borrow funds against their outstanding invoices. Invoice financing is somewhat like a line of credit or traditional loans, wherein borrower pay the borrowed amount back to the lender with fees.
In addition to this, in invoice factoring, the factoring company has ownership of borrower’s invoices, which makes them liable to take responsibility for collecting them. This can be beneficial for many small business owners as they don't have to chase customers to pay the outstanding bills. On the other hand, some businesses do not prefer to interrupt their relationships with customers by having a third-party collect payment. With invoice financing, you remain responsible for collecting your payments from customers.
Invoice factoring is emerging as a noteworthy financial instrument for various small businesses. Instead of worrying about outstanding payments, one can leverage them for availing of funds so that business operations never get interrupted. One can also choose Working Capital Loans, and Small Business Loans to avail of funds instantly when in need.
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