stressed man with debt

What is Debt Factoring?

Last Updated on August 26, 2021

Business owners always seek out ways to leverage their assets. Debt factoring is a specific form of financing designed to help partners and managers reach short-term business goals.

Debt factoring is based on selling accounts receivables to an entity that pays a fee for those accounts receivables. The third-party entity offers the seller a percentage of the total value of the accounts receivables.

It enables businesses to obtain convenient access to funding before the customers pay for the services or goods they received. Debt factoring is sometimes referred to as invoice factoring or invoice financing.

The best way to understand debt factoring is to analyze the parties involved in contracts, the advantages and disadvantages.

How Debt Factoring Works

Debt factoring features three entities: a debt factoring company, a client, and a business entity.

The factoring company (factor) purchases the accounts receivable invoice from the business entity. The client then pays the factor as the invoice comes due. A factor may be a financing company or an investor.

The client is the individual or company who purchased the service or product. The client is obligated to pay the factor for the service or good.

The business sells services or goods. Businesses allow customers to pay for services or goods at a date after receiving the services or goods.

Advantages

Giving businesses convenient and fast access to operating capital is the primary advantage of debt factoring. Businesses can increase their cash reserves or purchase securities with the proceeds from debt factoring.

Financial institutions or debt factoring brokers can perform debt factoring contracts. If a business wants to save time then contracting with a debt factoring broker is more efficient.

Accounts receivables are transformed into cash quickly: businesses do not have to wait for customers or clients to pay for goods or services.

Businesses using factoring can devote their attention to marketing and selling their goods and services rather than collecting debts. Saving time and business assets can promote efficiency.

An additional advantage of debt factoring is streamlined cash flow. Reviewing contracts quarterly can help businesses increase production and growth. Businesses can purchase equipment and supplies or focus on paying expenses related to wages, taxes, and inventories.

Yet another advantage of debt factoring is the freedom from having to put up collateral for a loan or overdraft. Loans typically require the debtor to assign rights to collateral to a third party lender. Being free from these security interests will enable a business to operate in a more spontaneous manner.

Cash flow stability is a final advantage of debt factoring. Late payments and collection fees can weaken a business’s growth predictions. By factoring, and focusing on providing goods and services to new customers, businesses can use their resources to increase productivity.

Disadvantages

The fees are the biggest drawback to using this form of financing as a cash flow tool for businesses. The debtor’s credit score and the extent of the contractual relationship are factors that will influence the price of the arrangement.

The fee for debt factoring begins as low as 1% of the total value of all the accounts receivable associated with the transaction. If the invoice remains unpaid then the fee will increase over a particular interval of time.

Debt factoring brokers can also charge a flat fee to perform factoring arrangements. This flat fee will depend on various factors:

  • Business stability
  • Quarterly or annual sales volume
  • Payment terms and late fees
  • Customer creditworthiness

These factors will contribute to the actual number the debt factoring broker uses to calculate the flat fee arrangement. Business managers and officers should compare the costs associated with using debt factoring brokers.

No company is guaranteed to collect unpaid invoices. The factor may demand that the business purchase all the unpaid invoices or replace them with other invoices of equal value.

The factor will collect the invoices and it is not guaranteed that they will use ethical practices when attempting to collect their money from customers. Businesses may need to investigate the factor to make sure the company abides by the best practices standard.

Is Debt Factoring Right for Your Business?

Small business owners are more likely to use debt factoring out of necessity if they are unable to obtain operating capital through a bank loan or a line of credit. Larger companies may have access to reserves of capital. Many different businesses can benefit from this type of financing, but small and medium-sized businesses will be prime candidates for using it as a regular component of their business operations.

Debt factoring will become more pervasive as business owners use more flexible business strategies and tactics. Every entrepreneur, officer, and manager can benefit from understanding how it can contribute to stable and healthy economic growth.