How Does Invoice Factoring Help Businesses?

If you own a small or medium-sized enterprise (SME) you may have heard of “invoice factoring”, and wondered if it could help you. “Factoring and invoice discounting,” as it is also known, is an alternative financing method that may help to leverage your business’s accounts receivable as an asset. (1)

To better understand how invoice factoring may help your businesses, you first need to understand how the process works. In the sections below, you will learn about what invoice factoring is and how it relates to the kind of cash crunches that smaller businesses can experience. You will also learn what it is that distinguishes invoice factoring from a bank loan, and some of the benefits this can offer to businesses with a certain profile. Finally, you will find some evidence for the benefit of approaches such as invoice factoring in a particular sector—in this case, the trucking industry. Trucking uses the term “freight factoring” to describe the same process, which this guide explains.

Armed with relevant information, you can speak to a financial advisor about which options might be the best for you and your business.

What Is Invoice Factoring?

Put simply, factoring is “a financial service enabling enterprises to sell their accounts receivable to a factoring company in exchange for cash.” It can help to think about how this might actually look in a given industry. (1)

A 2017 article in The Economist lays out one example of how invoice factoring works. Take a farmer as an example. After harvest, the farmer might have to wait a year to receive payment. With buyers seeking to conserve cash, they often keep from paying for as long as they can. A survey by a financial firm found that 47% of suppliers had issues with late payments. What if the farmer could sell the invoice for their crop instead? They would receive the cash more quickly, minus a small fee from the company buying it. That company would then collect the payment from the buyer when it was due. The technique works by taking “advantage of buyers’ low credit risk to pay suppliers’ invoices promptly.” (2)

Writing in the Oxford Handbook of Entrepreneurial Financing, Khaled Soufani lays out how invoice factoring can help us to understand the role of SMEs in the economy. SMEs face a particularly high amount of uncertainty around “cash flow and future liquidity requirements.” This means that they need to be very careful with their financial management. For the many enterprises that sell goods on credit, they have a useful asset in their accounts receivable. (1)

Accounts receivable can be a cash soak for SMEs, and invoice factoring is a way to avoid relying on credit cards, bank credit, or overdraft services. The practice is used in many different parts of the world, and is something that fintech firms are trying to provide as well. (1)

Overcoming A Cash Crunch

SMEs don’t have the same access to capital markets as larger firms. For example, they cannot issue stocks or bonds, or use other mechanisms available to bigger businesses. When a small business experiences a crash crunch, there are five typical options, according to Soufani:

To “increase short-term bank borrowing”
To “delay payments to trade creditors”
To “get a cash-injection” from people close to the business owner.
To consider “leasing options”
To consider “factoring their accounts receivable” (1)

These cash crunches can be hard to avoid, because SMEs have a limited number of tools for “short-term cash management”; these include the following:

Forecasting the inflow and outflow of cash.
Investing cash surpluses that arise from seasonal shifts or similar changes.
Managing overhead to increase the inflow of cash and decrease the outflow.
Maintaining a good relationship with a banking institution to help meet cash needs.
Funding from the owners or from others close to them. (1)

All of this helps to explain why an alternative method of financing, such as invoice factoring, may offer benefits to SMEs.

Benefits of Invoice Factoring Versus a Bank Loan

One way in which factoring companies contend that they can help a business is by doing things that a bank can’t. Keeping in mind that the main benefit of factoring is as Soufani says “primarily in cash flow and supporting companies suffering from short-term cash shortages,” here are some of the others:

Can be done fast and easily, while a bank could take weeks or longer.
Can help a company even if it has a cash-flow problem.
The SME does not incur any debt.
There is no monthly payment, which avoids any pressure on cashflow.
May provide protection against bad debt.
The client does not put up real assets as collateral, unlike with a bank loan.
Factoring companies may offer advisory services.
Factoring companies build up a specialized perspective of a given industry, and therefore can offer more expert advice. (1)

There are more ways in which invoice factoring can help businesses, but it’s also useful to examine cases where the kind of increased liquidity offered has helped industries in the real world.

Trucking—A Case Study For More Liquidity

Is there evidence for the efficacy of a technique such as invoice factoring? In certain industries, like trucking, “freight factoring” has long been a common practice. For businesses in industries with long wait times between delivery and payment, it can be hard to stay afloat during that time.

A statistical analysis from 2015 looked at how long payment terms made it harder for “liquidity-constrained firms” to enter the market, and to stay afloat once they have. In his analysis, author Jean-Noël Barrot looked at the impact of a single change in regulatory law around the trucking industry in France. When these long payment terms were restricted, Barrot found that “trucking firms’ corporate default probability decreases by 25%” and there was also “an increase in the entry of small trucking firms” into the market. Tools like invoice factoring could help to provide the same kind of liquidity. (3)

Conclusion

All of the information above should give you a better idea of how invoice factoring can potentially help SMEs. Like any approach to financing, there are pros and cons, and your business’s specific needs should be taken into consideration. If after reading this, you’re interested in invoice factoring for your SME, make sure to speak to an accountant or another financial professional.

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