Although debt factoring appears to be a convenient way to produce immediate cash flow, a thorough analysis reveals that debt factoring has both advantages and disadvantages.
While inherent disadvantages may cause a business to reconsider using such a service, advantages are also more diverse than one may assume.
What Is Debt Factoring?
Debt factoring is an alternate term for invoice factoring and occurs when a business raises accounts receivable, often in the form of invoices, and passes them to a debt factoring company for them to grant a cash advance of up to 100% of the invoices’ value.
The factoring company additionally pursues collection of the owed payment on behalf of the customer – when the payment is made, the residual value that was not initially forwarded is delivered to the business minus predetermined fees for the service provided.
The more you go through our invoice finance product pages, the more you’ll realise that this increasingly popular cash flow solution comprises a diverse range of solutions, each tailored to different businesses in different economic situations.
Debt or invoice factoring is appropriate for companies that need assistance managing their sales ledger. Alternatively, some businesses that have spent years developing their in-house credit collection systems prefer to retain control of their sales ledger, which means they will frequently turn to invoice discounting facilities or factoring financiers who allow clients to handle their own credit control (CHOCS).
What is the Process of Debt Factoring?
Debt factoring comprises three parties: a business, a client, and a debt factoring company.
- A business can be any company that sells goods or services and allows its consumers to pay for what they receive later.
- The customer is the entity or person who purchased the goods or received the service and is the party who is expected to pay.
- When an invoice is due, the debt factoring company purchases the original invoice from the business and collects payment from the client. It could be a company or an investor.
Typically, the debt factoring company pays the business a sizable portion of the initial debt the client owes as soon as they purchase the invoice. The debt factoring company then releases the remaining percentage of the original amount payable by the customer, minus a factoring charge, once the entire payment is received from the client.
Debt Factoring Worked Example
A business makes £100,000 in monthly sales. Customers have 60 days to pay their invoices. At any given time, the business has roughly £200,000 in consumer debt (receivables). To increase its liquidity, the business has to raise capital.
Options:
(1) Wait for invoices to be paid by customers (e.g. 60 days)
(2) Sell these invoices to a factoring company for immediate cash payment (but at a discount)
Using option (2):
The business now receives up to 90% of its invoice value in cash (£180,000).
The debt factoring company then collects the invoice payment from the consumers and returns the remaining 10% of the invoice value LESS a fee – normally around 3% – to the business. As a result, the business receives approximately £14,000 for a cost of £6,000 in this case.
Debt Factoring Requirements
If you want to use a debt factoring service, you must first determine whether you meet the following qualifications:
- Debt factoring financiers prefer clients who can demonstrate a stable annual turnover of £50,000 or more for several years.
- Most debt factoring funders will only work with enterprises situated in the UK, rather than firms based elsewhere with UK branches/commercial activity.
- You must also guarantee that the credit terms you provide your clients when raising invoices range from 30 to 90 days.
Advantages of Debt Factoring
Invoice factoring provides a variety of practical benefits to firms, including enhanced cash flow, debt protection, and speedy purchasing, which should be carefully evaluated during the decision-making process. These advantages might help your business thrive by reducing your dependency on upcoming payments.
The list below comprises a variety of advantages provided by invoice factoring. Read on for more information on each perk (click on the links to jump to each section).
The following are the primary advantages of debt factoring:
- Increased cash flow
- Reduce the cash flow cycle
- Purchase in a hurry
- Rapid development
- Improvement
- Debt repayment
- Cost-effective admin
- Debt collection that is cost-effective
- Mindfulness
- Options for Financing
#1. Increased cash flow
The primary purpose of factoring, and thus the primary advantage, is to quickly raise cash. It is a method of collecting the money owed to you by your clients without having to wait for them to complete the transaction.
Although you will be expected to sell the invoices at a discount, this must be examined in the context of the larger picture. You will not waste time, money, or resources administering and processing invoices.
Start-ups, small enterprises, and entrepreneurs require capital to expand. It can mean the difference between embracing an opportunity and expanding, or stagnating and losing out. As a result, receiving cash injections to boost cash flow is the primary benefit of debt factoring. You could have money in your hands in as little as a day or two.
#2. Reduce the cash flow cycle
Many smaller businesses struggle as a result of the expected and normalised time lag between work or order completion and payment. This temporal lapse can have serious consequences. One of the advantages of debt factoring is that it might shorten that cycle and get you paid sooner.
#3. The ability to make swift purchasing judgements
If you need to buy supplies, make repairs, or get new equipment right away, factoring is a great option to receive the money you need.
#4. Rapid development
If you are given the opportunity to take on a new client or a major order or project, you may need to rapidly expand in terms of people and capacity. Debt factoring might help you increase your operating capital.
#5. Taking the business to the next level
Due to a lack of funding, entrepreneurial businesses may be unable to expand their service offerings or develop new product lines that will ultimately benefit their bottom line.
#6. Protection from bad debt
One of the primary advantages of factoring is that it removes part of the risk of bad loans from your hands. To accomplish this, you must select non-recourse factoring. This will be reflected in the ‘discount,’ where you will pay greater factoring fees because you are minimizing all risk. It, however, safeguards your business from any loss if a debtor fails to pay.
#7. The administration that is cost-effective
Smaller organisations, where employees frequently take on multiple jobs, may rapidly discover that financial administration is a time- and resource-consuming process that does not pay. By delegating invoice administration to a debt factor, you will free up important labour time that can be used to build your business. This can also benefit your bottom line by lowering considerable administrative costs.
#8. Cost-effectiveness of debt collection
If you have to hire debt collectors, you will have to pay a significant fee. It is often much higher than 20% of the loan’s value. The rates for factoring are substantially lower, and the factoring company will handle delinquent invoice collections.
#9. Peace of Mind
As a business owner, debt factoring can provide peace of mind that your financial demands will be satisfied and that you will be able to satisfy the needs of your business.
#10. A finance solution that is viable
Debt factoring is a potential financing solution for businesses that are unable to obtain a bank loan.
Disadvantages of Debt Factoring
Along with the advantages of debt factoring, there are some significant disadvantages to consider.
The following are some of the disadvantages of debt factoring:
- lowered bottom line
- Involvement of third parties
- Customer care
- Bad-debt liability
#1. The bottom line has been slightly reduced.
Finally, debt factoring providers charge you factoring fees in exchange for taking on the risk of collecting unpaid invoices. As a result, you will earn less money from your invoices. However, the advantages of debt factoring significantly surpass this minor setback.
#2. A third party is given some business influence.
Factoring firms have particular expectations on how enterprises should be run. In general, they are not huge risk-takers. As a result, they may urge that you change the way you do things, such as the types of consumers you serve or the employees you use.
#3. Customer satisfaction and reputation
As a business owner, you understand how critical it is to keep a positive reputation with your consumers. One downside of factoring is that you lose control over the invoice payment process. Also, your chosen factoring company’s payment collection disadvantages may not be acceptable to your customer.
However, there are ways to efficiently manage the invoice factoring company’s involvement in order to retain excellent connections with your clients. In some circumstances, the factoring company’s influence is nearly imperceptible.
#4. Possibility of a bad debt obligation
It will depend on the terms of your factoring agreement, however, unpaid invoices may be returned to you under some agreements (such as recourse factoring contracts). This is especially critical if you have a large volume of invoices due from consumers with bad credit.
You can, however, reduce the likelihood of this by carefully regulating the types of invoices that you factor in. For example, it may be advisable not to include invoices from a client with a poor credit history. Invoice factoring providers will collaborate with you to pick the best invoices to factor in, thereby reducing risk for both you and them.
Considering the Advantages and Disadvantages of Debt Factoring
When deciding if debt factoring is right for your business, you should weigh the advantages and disadvantages of factoring. This must be done before executing any debt factoring arrangement. Understanding the advantages and disadvantages of debt factoring puts you in a far better position to negotiate and maximise the advantages of factoring for your business.
Choosing the Most Reliable Debt Factoring Company
The information on this page should help you understand what kind of advantages invoice factoring can provide for your business. You should chat with specialists immediately for more information, including comparisons of top UK providers.
What is a Typical Debt Factoring Fee?
The number of your invoices, your client’s credit history, the sector you work in, and the general viability of your own business all affect the cost of debt factoring.
Factoring has two main fees: the advance (a percentage of the cash you’re provided up front) and the rate (which is the cost of financing).
Rates range from 1.5 percent to 4 percent per 30 days, with average advances of 75–85 percent.
How Does Debt Factoring Improve Cash Flow?
Once the factoring agreement is in place, businesses no longer have to wait impatiently for consumers to clear their invoices each payment cycle. Businesses can benefit from guaranteed cash flow by having the debt factor pay the advance on the same day each month, giving them more time to do what they do best.
Factoring may revolutionise a company’s day-to-day operations, especially for organisations with a small number of high-value invoices and a solid profit margin.
What are the Risks of Debt Factoring?
If you understand the terms (and have ensured that there are no hidden prices, charges, or exit fees), the biggest risk of debt factoring is that if a customer does not pay and you have already received the advance, you will become liable for that debt.
Many of these hazards can be reduced by selecting a reputable and trustworthy element and only employing it when absolutely essential. Many firms have operated successfully for years with factoring in place.
Is Debt Factoring a Long-Term Strategy?
Debt factoring is typically used as a short-term cash flow solution for businesses looking to expand their working capital cycle.
However, in some cases, such as when a business has a high-profit margin and a small number of clients, factoring may be beneficial in the long run. Profit margins, in that case, indicate that factoring may be considered acceptable.
