As a small business owner, you’ve started a journey to support yourself by doing something you love and are passionate about. It’s empowering to break out on your own and chart your own course. But, unfortunately, following your dreams doesn’t guarantee a steady stream of revenue.
Getting paid on time is something many entrepreneurs struggle with when starting their own business. In fact, 7 in 10 microbusiness owners report waiting anywhere from 1 to 6 months to get paid. Even worse, 25% wait up to a year — or don’t get paid at all.
What some customers don’t seem to understand is that those late payments can leave businesses short on making rent, paying staff, and halt operations altogether. If you’ve found yourself in this scenario one too many times, perhaps it’s time to consider alternative financing solutions.
For example, invoice factoring or account receivable financing are both excellent solutions to resolving poor cash flow. In this blog post, we’ll explain the similarities and differences between the two so you can understand what option is better for your small business.
What is Invoice Factoring?
Invoice factoring is a form of invoice financing where businesses can auction unpaid invoices to factoring companies as a way of improving financial health. A third party will immediately pay you a majority of the invoice and collect payment directly from your customers. Once customers pay the invoice in full, the lender will advance you the difference minus a fee for their service.
Invoice factoring example
Let’s say you are Company XYZ. You send a $10,000 invoice to Blank University for an order of school-themed apparel. The invoice is Net 60, therefore Blank University does not have to pay the $10,000 invoice for another two months.
However, you need that money a lot sooner. To quickly receive the money you are owed, you contact an invoice factoring marketplace, such as Crowdz.
Investors purchase your invoice and send you $9,250 almost immediately. You’re able to use those funds for any business purpose.
The investor who purchased your invoice follows up with Blank University to collect payment. The University sends the check directly to the investor. The investor deducts their fee of 5% and sends you the remaining balance. In total, you receive 95% of the invoice value or $9,500. Whereas, the investor receives $500 in fees
What is Account Receivable Financing?
Account receivable financing is similar to invoice factoring in that you can sell outstanding invoices to factoring companies for instant working capital. How receivable financing differs is that you keep ownership of the unpaid invoice and are responsible for collecting payment from customers.
Account receivable financing example
Let’s say Company ABC sells pencils. It has about $10,000 in outstanding receivables from people who have not paid for their pencils. However, Company ABC needs that cash as soon as possible because it wants to buy more inventory.
Because the $10,000 is expected to arrive within the next 90 days, it is considered an asset. Therefore, Company ABC partners with a factoring company that purchases the receivable for 90% of the value ($9,000). Company ABC receives the money almost immediately.
Over the next several weeks, Company ABC repays the factoring company in smaller increments, with a predetermined interest rate. Additionally, Company ABC keeps control of collecting payments from its customers and uses that money to pay back the factoring company.
Invoice Factoring vs Account Receivable Financing: What’s the Difference?
Although the terms invoice factoring and account receivable financing are often used interchangeably, they are not the same.
The two terms are similar in that factoring companies assume the risk of customers paying late or not paying at all. For this reason, factoring companies review the credit history and other financials of your customers before purchasing the invoice. If the credit history is good, they will be more confident in making the agreement.
So, what’s the difference?
With account receivables financing, invoices are used as collateral for the loan. In this financing option, you still communicate directly with customers and are responsible for accumulating payments for outstanding invoices.
Whereas, under an invoice factoring contract, the receivables are sold off to investors or an account factoring firm. In this situation, the factoring company is responsible for the payment collection process.
In other words, the big difference is that the factoring company communicates with your customers for payment, rather than you tracking them down to get paid. However, because the invoice factoring company takes on more of the payment collection responsibilities, they typically charge a higher percentage than account receivables financing.
Many new business owners can be overwhelmed with the difficulties of maintaining a positive cash flow or just breaking even. There are several strategies to persuade customers to pay on time, such as offering discounts for those who pay early or utilizing an online accounting system. Still, these tricks might not be effective enough.
In this case, invoice factoring and account receivable financing are possible solutions for overcoming cash flow challenges. While slightly different in their own ways, they both offer small business owners an alternative funding option to get paid quickly on outstanding invoices.
For more business financing tips and tricks, head over to our blog. We post new content each month to fuel entrepreneurs with the knowledge they need to launch their business off the ground.