Small and medium-sized businesses are increasingly using debt factoring as a method to instantly access capital and speed up their processes. As a small business owner, it is useful to have a solid understanding of what debt factoring is, the types of debt factoring, and what the benefits and problems are. Keep reading for our short introductory guide.
What is Debt Factoring?
Debt factoring, also known as invoice factoring, describes the process of a business selling their outstanding invoices to a third party at a discounted price. This can improve cash flow and stability as a business avoids waiting times associated with invoice payments. The third-party, or factoring company, will then pay most or all of the invoiced amounts to the business immediately and collect payment from the business's customers.
Debt factoring is also sometimes referred to as invoice factoring or accounts receivable factoring. All three terms describe the same concept.
How does Debt Factoring work?
Once you have decided to use debt factoring services, your company will sell its outstanding invoices, either partly or in full, to a debt factoring company. Initially, you provide your goods and services to your clients (as usual). You then invoice your clients for those goods and services. These invoices over accounts receivables are then sold to a third party, the debt factoring companies. The factor will assess the level of risk by looking at your debtors' financial health. Based on this, they decide what percentage of the invoices they can factor. Debt factorting companies typically pay the majority (typically around 80%-90%) of each invoice payment. Your clients' payments then go directly to this third party. Once the payments have been made to the factoring company, you will receive the outstanding amount of each full invoice value.
Charges for debt factoring
The cost associated with debt factoring will depend on the invoice amounts outstanding, the reliability and financial health of your debtors, and the sector your business is in. The cost of financing, called the rate, is typically around 1.5% to 4% per 30 days.
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Types of Debt Factoring
CHOCC Factoring
CHOCC factoring is short for ‘Client Handles Own Credit Control'. This means that you can still chase unpaid invoices from clients yourself, even after you have factored. This can be a useful option if your business doesn’t qualify for invoice discounting because it is in its early stages. Also, this can help manage your customer relationships more directly.
Confidential Factoring
When deciding on this type of factoring, your clients are not made aware of the fact that you are using a factoring company. You may choose confidential factoring as it combines the cash advance with the confidentiality of invoice discounting.
Disclosed Factoring
This refers to the common type of invoice factoring, where your clients are made aware they are dealing with a factoring company.
Recourse/ Non-Recourse Factoring
Recourse factoring, the more common type, means that your business is obliged to buy back any outstanding invoices from the third party that they cannot collect payment for. Non-recourse factoring, on the other hand, means the factoring company assumes most of the risk of non-payment. However, you will still be left with a significant amount of risk. Most recourse agreements describe specific situations in which you are not responsible for payment (eg only if a debtor declares bankruptcy).
Advantages of Debt & Invoice Factoring
- Invoice factoring is a cheaper and easier option to improve immediate cash flow than getting a bank loan. You can save money and time spent on debt management and still benefit from improved cash flow.
- Invoice factoring can also reduce your company's overhead costs. While there are factoring fees, they tend to be lower than the cost of paying dedicated credit control staff. Debt factoring can also improve the work ethic of accounting teams, as chasing invoices can be a very tedious task.
- Through improving your cash flow, one of the debt factoring advantages is financial security. Many businesses fail due to poor cash flow, which you can help prevent through smart debt factoring.
- Overall, invoice factoring makes your business's cash flow more predictable. With the bulk of your invoices being paid promptly, business planning and forecasting will be more accurate.
Disadvantages of Debt & Invoice Factoring
- Most agreements with invoice factoring companies will include the majority of the invoices you issue. This means that debt factoring can be a significant commitment for your business. Many contracts will also run over at least two years which makes this an important and impactful business decision.
- If your business is small and only has a handful of clients, invoice factoring might not be for you. Factoring companies want to spread their risk over as many clients as possible.
- When entering a contract, factoring companies will pay close attention to your client portfolio. If your clients are seen as high risk, you may encounter higher fees.
- Of course, your relationship with your customer base is likely to be impacted by your choice to go to a debt factoring company. With this, you are handing over a part of your customer management. If the factoring company pursues the debt in an aggressive manner, you risk your customers being put off.
- If your clients fail to pay, you will most likely have to reimburse the amount the factoring company has already paid you, unless you pay extra for non-recourse factoring. Costs of the process not working can be significant.
Is Debt Factoring a long-term solution?
Companies tend to use debt factoring as a short-term cash flow measure to increase working capital. However, for businesses with a high profit margin and few clients, debt factoring could be a valid long-term strategy.
Debt Factoring FAQs
- Is factoring considered debt?
Whilst debt factoring provides instant working capital, it also leads to short-term debt. Of course, this should be paid off as soon as the clients pay their invoices, however, if there are any issues, this can lead to bad debt.
- Is debt factoring short or long term?
You can expect payments from debt factoring companies to arrive promptly. This means your short-term cash flow will improve. However, many companies will require you to enter into a long-term contract, so debt factoring is a long-term business commitment.
- Is debt factoring internal or external?
The process of debt factoring means selling your outstanding invoices to an external company. These factoring companies will pay you the bulk of the invoice amounts and then collect payment from your clients.
- How does debt factoring improve cash flow?
Debt factoring can improve cash flow and stability as a business avoids waiting times associated with invoice payments. The payments for outstanding invoices are made immediately by the third party that then chases your clients for payment.
