Small Business Finance Options – Invoice Factoring 101

Invoice factoring is a useful but often misunderstood element of small business finance. So in this article, I’ll explain what factoring is and how it can help certain business owners sustain their growth.

By way of definition, factoring is a process through which small business owners can convert accounts receivable (invoices) into much-needed working capital. Basically, there are three primary parties involved in the process:

  1. The Invoicing Company – This could be any company with accounts receivable in the form of invoices. Additionally, the company’s owner wants to convert those invoices into much-needed working capital. For this example, let’s refer to this business as “Acme Corp.”
  2. The End Customers – These are the customers who have been invoiced by Acme Corp and are thus part of Acme’s accounts receivable system.
  3. The Factoring Company – This is the financing company that specializes in providing working capital through such services as invoice factoring. This is where Acme Corp will go to try and convert their invoices into working capital, a.k.a. cash flow.

Now let’s assume that next month will bring some major equipment purchases for Acme Corp. They need two new vehicles for their business, along with some other equipment. The only problem is, a lot of their capital is tied up in the form of invoices. This represents future revenue, but it doesn’t help Acme Corp here in the present, and it won’t help them make those equipment purchases next month. In other words, those invoices are not considered working capital.

In this common scenario, a small business factoring company could step in to help Acme Corp transform their accounts receivable into working capital (which could be used to make those equipment purchases next month).

So Acme’s owner (Bob Smith) would work with a factoring company to transfer some or all of his invoices to the company. The factoring company would then advance Bob a portion of the invoice total, typically around 80 percent. Bob has just converted 80 percent of his accounts receivable into capital that he can use to cover those equipment purchases.

The end customers (the people who owed Bob those invoices) would now make payments to the factoring company, instead of sending them to Acme Corp.

This approach to financing is not for every business. Like any other financial strategy, there are many considerations that must be taken into account. But the point of this article is not to say whether or not factoring is right for your business, but merely to make you aware of this unique approach to small business finance.