Debt factoring is an external, short-term source of finance for a business. With debt factoring, a business can raise cash by selling their outstanding sales invoices (receivables) to a third party (a factoring company) at a discount.
Worked example of Debt Factoring
A business makes sales of £100,000 per month. Its customers are given 60 days to pay their invoices. On average, the business has around £200,000 owed by customers at any one time (receivables). The business needs to raise cash to improve its liquidity.
Options:
(1) Wait for customers to pay their invoices (e.g. 60 days)
(2) Sell these invoices to a factoring company for cash now (but at a discount)
With option (2):
The business gets up to 90% of their invoice value in cash now (£180,000)
The debt factoring company then collects the invoice payment from the customers and sends the remaining 10% of the value of the invoice to the business LESS a fee – typically around 3%. The business therefore receives around £14,000, costing them £6,000 in this example.
Benefits and Drawbacks of Debt Factoring
Benefits
- Receivables (amounts owed by customers) are turned into cash quickly!
- Business can focus on selling rather than collecting debts
- The facility is practically limitless and therefore suits a fast-growing business.
- There is no security required – unlike a loan or overdraft.
Drawbacks
- Quite a high cost – the charge made by the factoring company, typically around 3%
- Customers may feel their relationship with the business has changed
