Sometimes the biggest challenges for construction companies come from the flow of money in and money out. While money tends to come in at fits-and-spurts, it flows out fast. This can present a problem when companies find they run out of money to cover their expenses. Contractors have come up with a few ways around this problem to keep a project running in the face of a cash flow crunch. One of those methods is called invoice factoring.
Invoice factoring is like borrowing against your receivables. It’s a way to turn unpaid invoices and accounts receivable into quick cash for a cost.
In invoice factoring, you give over your outstanding balances to a factoring company, which pays you a portion of the balance in cash immediately. Your clients then pay the factoring company directly. At this time, the company will pay you the remaining money owed minus a fee, which is usually a percentage of the invoice amount.
Factoring can be a useful financial tool for a contractor, by helping to cover costs when money’s tight. However, it shouldn’t be taken lightly, as it comes with its own costs and risks. Here we’ll talk about why a contractor might consider factoring, the benefits and risks to its use, and alternative methods of accessing cash.
Types of factoring
Factoring contracts typically fall into one of two categories: spot factoring or contract factoring.
Contractors use spot factoring to bridge a one-off gap in the cash flow. For example, a business owner may use spot factoring when a sudden, unexpected expense emerges, but the business is unlikely to use the service regularly.
By contrast, contractors may use contract factoring when a company hopes to use factoring regularly to speed up payment on all their invoices. Rather than waiting for the net 60 terms to close, a contractor may choose contract factoring to get paid just days after an invoice is submitted. The fees for contract factoring will be lower than the cost of spot factoring, so if you want to use the service often, it may be the best choice.
Why you might consider factoring
Keep the wheels turning
Cash Flow is king in construction, but as complex as the projects are, it's tough to maintain a balance between payments coming in, well, whenever they come in, while expenses keep rolling out on a regular schedule. If you have trouble making this work, you might consider factoring, which can help keep payments stable and predictable so you can cover operational expenses.
Keep bids moving
The only way to grow a contracting business is to keep bidding on larger projects, but that growth requires a bit over overhead. Taking on more extensive work means new equipment, more laborers, and more administrative fees, but the more significant money won't start flowing until after the work is well underway. Factoring can help keep the cash coming in at regular intervals to pay for this change.
A sudden need for cash
You may be a cash flow ninja, but now and again, every business sees an unexpected expense. Maybe an expensive tool just broke, or a project has a spontaneous design change that will jack up the costs. You may have to find some cash to cover ongoing expenses in these situations.
Is invoice factoring in construction a good idea?
There are a lot of benefits to this type of transaction. First, collecting on unpaid bills is nobody's idea of a good time. Factoring takes the collection's process off your hands.
Extra cash at a critical point in a project can be a huge advantage. It can take months to get paid in construction after a company submits an invoice to a client. And yet, the expenses keep coming: labor, materials, and equipment costs, to name a few. Factoring gives you access to cash, which can help bridge the funding gap.
There are other ways to get cash, like a business loan, but factoring is often faster and more accessible than getting a business loan. Finally, you don't have to leverage your capital assets to secure cash when you use factoring like you may have to do to secure a bank loan.
The downsides of invoice factoring
The main downside of invoice factoring is pretty obvious: you are losing out on a portion of your revenue. Factoring fees are generally costlier than the interest on a business loan – often running 1-4% of the face value of the invoice for every week or month the cash is outstanding. In an industry where there's not a lot leftover for the contractors when the job's all done, adding another cost is not ideal.
Loss of control
If one of the main benefits of factoring is that you don't have to worry about collections on your invoices, the flip side is that you lose control over the collections on your invoices.
Depending on your contract with the factoring company, you may be giving up communications with your customer. In construction, relationships are everything, so you have to be careful what messaging the factoring company uses when they reach out regarding unpaid invoices.
What are some alternatives to invoice factoring?
If invoice factoring sounds like something you'd rather avoid, you'll have to find other methods of keeping cash on hand for even the most demanding financial times.
Opt for business loans
Business loans are the more traditional method of bridge financing. There are more hoops to jump through to get loans from a bank, though: you'll have to prove your credit history and show that you can repay the loan. With a little bit of lead time and a solid business history, though, a business loan from a bank can be a more affordable option to finance your contracting business.
Manage your cash flow
Alternatively, you could opt for a do-it-yourself method and manage your cash flow well enough to have cash on hand when the unexpected happens. Of course, this is easier said than done. If your business regularly has spare cash in the bank, you should go kiss your accounting and AP staff because they are saving you a lot of headaches. If you need a little help in this department, digital solutions like MazumaGo or Check The Level can help you achieve your cash flow management goals.
Faster receivables collection
One way to ease the cash flow crunch is to minimize the friction points between invoicing and payment. Digital tools can help here, too. With MazumaGo, you can ditch the whole paper processing routine and send digital invoices that include payment links. Track payment in real-time and send "payment reminder" messages for outstanding invoices.
Keep the cash flowing to keep invoice factoring to a minimum
Invoice factoring is a tool that can help your business keep rolling when cash is tight. It's useful in a pinch, but given its associated costs, you don't want to use it too often.
You'll also want to keep more traditional cash flow tools at the ready, like business loans.
Use digital tools to manage your cash flow better, so you don't wind up in a pinch. Finally, keep the cash flowing by greasing the wheels to make payment a breeze for your clients. Find out how online payment processing can help make payment faster and easier for your clients, here.