Payday 101: How Does Payroll Funding Work?

About 44% of small businesses don’t have enough cash on hand to cover three months of expenses. If there’s another shutdown because of the pandemic or the economy slows down, these businesses will be in trouble.

A larger tax bill than expected or a business emergency can cause those funds to dwindle to nothing. Then you’re in a financial downward spiral.

You have to pay your employees. You’re expected to come up with the cash, but how will you manage? Payroll funding is one way to get cash in the door quickly.

How does it work? Keep reading to learn the basics of payroll financing.

What Is Payroll Funding?

Payroll is the largest expense for employers. Businesses typically spend anywhere between 30%-65% of revenue on payroll expenses.

Of course, you need to have enough business to support those employees. Businesses understand that they also pay payroll taxes, benefits, and insurance on top of salaries.

They always make sure they have enough revenue to pay employees. Where they get tripped up is in managing cash flow.

Your employees expect to get paid twice a month. You decide if that’s the first and third Fridays, second and fourth Wednesdays, or other days that work for you.

Your customers might not always pay on time, which creates cash flow issues. They might fulfill large contracts with purchase orders, leaving you unable to collect for 60-90 days.

You could look at closed sales and think your business is fine and dandy. Then you look at your bank account and start stressing out.

Payroll funding fills the gap in cash flow. You take out a loan and use your outstanding invoices and purchase orders as collateral on the loan.

You’re essentially selling your outstanding invoices for the loan. When the customers pay their invoices or purchase orders, the funds go to the lender.

This type of funding is also called invoice factoring. You don’t work with a traditional lender like a bank for payroll funding. Instead, you work with a factoring company.

Certain industries have to rely on payroll funding to get by. Staffing, healthcare, and manufacturing are a few examples. It’s common for customers to wait 60-90 days to send payment.

How Payroll Funding Works

Payroll financing is a pretty simple process. The first step is to figure out how much money you need to borrow.

Look through your outstanding invoices and see which ones you want to use to secure the loan. Be sure to pick the invoices for your most reliable customers.

The factory company wants to make sure that your customers will pay. In a typical loan situation, a bank looks at your credit history or the credit history of your business.

That’s not the case here. Remember, you’re using your customer’s ability to pay as collateral. That’s what a factoring company looks at before they approve your payroll financing.

Contact a few factoring companies and get loan offers. Some online companies get quotes from lenders on your behalf.

Factoring companies will offer you a percentage of the total of the invoices. This varies depending on the factoring company.

Expect to receive at least 80% of the total. Some companies might offer 95% if your business financials and customers’ credit are solid.

If you have invoices totaling $10,000, you should get $8,000 to $9,500 as a loan. When your clients pay, that amount gets subtracted from the amount you owe the factoring company.

Factoring companies might charge administrative and origination fees, which come out to about 1%-3% of the loan.

If you accept the offer, you’ll get the money in your account and move on. The factoring company will work with your customers directly to ensure prompt payment.

Can Payroll Funding Be Used for Other Expenses?

You might wonder if payroll funding can only be used for payroll or a payroll taxes fund. Check the terms and conditions of the loan.

Some lenders give you flexibility, while others don’t. If you need cash for other purposes, you might look at other loan options.

Advantages and Disadvantages of Payroll Financing

Payroll funding is helpful to all businesses, but it’s not always the best choice. For instance, if you have a low profit margin, you can’t afford to take less than the full amount owed by clients.

However, if you have higher profit margins like 15% – 20%, then you can take advantage of payroll funding.

The other disadvantage is that you might lose control of the client relationship. For instance, if the factoring company has to contact your customer, it will catch them off-guard.

On the other hand, payroll financing offers many benefits. The main benefit is you have improved cash flow in your business.

It’s also a much easier solution to a cash flow problem. You don’t have to apply to get a loan and wait weeks to get approved. Payroll funding happens very quickly.

You could get funds deposited into your account in a matter of days with the right lender.

The most important reason to consider payroll funding is that your employees need to get paid. If you miss a paycheck by a day or two, it throws their lives into chaos.

You won’t keep employees for long if they can’t trust that you’ll pay them. You’ll have high turnover rates and higher business costs.

Take Advantage of Payroll Funding

Your business relies on steady cash flow, but that’s difficult to do when your customers take at least a month to pay you.

With payroll funding, you can get paid on those invoices faster and get the cash you need to run your business. Don’t let your business or employees suffer because of cash flow problems.

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