Invoice Factoring Explained: Stable Cash Flow for SMEs
Why cash flow is crucial
The ability to capture a business opportunity often lies in having cash on hand. Entrepreneurs and business owners can master sourcing and sales channels to generate growth, but cash tied up in invoices limits their ability to execute their strategies.
In Asia, suppliers require significant down-payments before starting production, and the balance of payment upon delivery of the goods. After receiving the goods, a business must sell them and wait for their buyers to pay on credit terms. This creates a stretched payment cycle between the first payment to a supplier and the collection of payments from buyers. In times of rapid growth, this cash flow gap can put a business at risk.
How factoring helps
There are three parties involved in invoice factoring; the business owner (the seller), their client (the buyer), and the factoring company (the factor). To start, the seller will offer their buyer credit terms on an open account basis, as opposed to requiring a letter of credit from a bank.
Factoring an invoice means selling it to a factor (a financial institution) who will advance you up to 85-90% of the invoice value. At the invoice’s due date, usually after 30 to 120 days, the buyer will pay the invoice value in full to the factor who will return the balance minus interest to the seller. This process can also be known as invoice discounting or receivables financing.
The advantage of this for the seller is clear - they can immediately convert an invoice into cash, rather than waiting until the due date for the buyer to pay. This means that the seller has cash flow to deploy back into the business, and that cash flow is more predictable.
Further, it gives the seller the freedom to extend more favourable credit terms to their buyers, which can help broaden their potential client base. Lastly, factoring offers the seller additional protection, as invoices are insured against the default risk of the buyer.
Choosing a factoring partner
If your buyer presents a letter of credit, you will need to work with a traditional bank. However, factoring with a traditional bank can be cumbersome for small businesses as it entails annual subscription costs and personal guarantees from the business owner.
Offering your buyer open account terms with credit protection will often be preferable, as letters of credit are difficult and expensive for buyers to obtain.
This will enable the business to factor with non-bank financial institutions, such as fintech companies, which are more agile and SME friendly. Fintechs often cater to specific markets, with solutions tailored to the needs of small businesses that are difficult for traditional banks to address. For an SME, working with a fintech financing specialist will be the fastest and easiest path to securing consistent cash flow for their business.