Debt Factoring is a term used to describe invoice factoring. This involves a business raising an invoice for work completed or products sold, before passing it on to a debt factoring company who will pay the business upfront and assume responsibility for collecting the debt. In most cases, the business will be given as much as 85% of the value of the invoice, with the remaining balance (less the factoring fee) paid when the customer settles what they owe in full.
Here we take a look at how debt factoring works, what the process involves, and how factoring could be of benefit to your business.
It can often help to review a debt factoring example to understand how the process works. To this end, imagine a business that makes sales of £10,000 per month. Its payment terms allow customers to pay what they owe within 60 days, meaning at any one time the business could be owed £20,000 in receivables. If that business struggles with cash flow or liquidity, it might turn to debt factoring to improve its outlook.
With debt factoring, the business could sell the majority of its invoices (e.g. 90%) to a factoring company for an immediate cash payment. This would give the business £18,000 to work with. The debt factoring company will then attempt to collect the invoice payment from the customers and will send the remaining value of the invoice to the business, less a fee. In this example, if the factoring company charged 3%, the business would get back a further £1,400 meaning that they only paid £600 to the factoring provider.
Businesses have different financial needs, and many entrepreneurs and business owners wonder whether debt factoring is a long or short term solution. Factoring is generally considered to be a short-term source of business finance that helps with cash flow and to increase working capital.
In some circumstances, debt factoring can be a long-term solution, but this usually only happens if the business has a high-profit margin and a limited number of clients.
Factoring is a form of financing, but quite confusingly it’s often not considered to be a form of debt. This is because neither the factoring company nor the business issue or acquire any debt during the transaction. The funds provided by the factoring company are in paid in exchange for the business’s receivables (invoices) and so factoring is closer to a transaction than to a debt arrangement.
Debt factoring is an external source of business finance, since the funds originate from a factoring company that sits outside of the business.
Debt factoring is often viewed as a viable way of improving a business’s financial outlook. By using debt factoring against outstanding invoices, you’ll receive money from the factor immediately and won’t have to wait around for your customers to pay. Despite this, the process doesn’t come without its pitfalls. Below we summarise the major advantages and disadvantages of debt factoring.
Quick access to cash when you need it, with money usually hitting your business account with just 24 to 48 hours of submitting invoices for factoring.
Improved cash flow, as you no longer need to wait for your customers to make payment. You can put the money straight back into the business almost immediately.
Protection against bad debts, if you opt for non-recourse factoring. This means that if your customer becomes insolvent during the factoring period, your business won’t shoulder the cost.
A simpler collections process, whereby the debt factoring company takes responsibility for collecting invoices as they fall due.
A high-interest rate, as compared to financing sourced from a bank or building society.
The risk of straining customer relationships, in cases where the customer and factor do not have a constructive interaction. This can be avoided by choosing a reputable factoring company.
Bad debt liability, for businesses that use recourse factoring. In these cases, responsibility for unpaid sums will be passed back by the factoring company.
Higher fees for businesses with slow-paying customers, as more time and effort are required from the factoring company.
A major benefit of debt factoring is that it can help to improve the cash flow of businesses that use it. Rather than waiting for their customers to pay them, they can get their hands on capital as soon as the invoice has been raised. This means that businesses using debt factoring can pay their employees, suppliers, and other parties earlier, making them a better customer and giving them the financial space to grow.
To be eligible for debt factoring and other forms of invoice financing, your business will need to meet a number of criteria:
If your company meets these criteria, you may be eligible for debt factoring. To find out more, and to compare the alternatives, visit our quick and easy invoice finance comparison page.