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Debt Factoring: What you need to know

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Debt factoring illustration

What is debt factoring?

Debt factoring also known as invoice factoring, is a financial term that allows businesses to convert their invoices to immediate cash.

How does debt factoring work?

Debt factoring describes the process of a company selling out its unpaid invoices to another company to get instant cash needed for the advancement of the business. Instead of waiting for its customers to pay, they sell it to a third party (called a factoring company) at a discounted price.

The factoring company pays the business upfront and assumes responsibility for collecting the outstanding balance from the business’ customers. This process often improves cash flow and business stability, as the company does not need to wait until outstanding invoices are paid.

Once you decide to use a factoring service, you will sell out your outstanding invoices of the goods or services you offered to your customers, either partly or in full, to the factoring company. 

The factoring company determines the level of risk by checking the financial health of your debtors, and then they determine what percentage of the invoices to factor in. Majorly, factoring companies pay up to 80-90% of each invoice payment.

Types of Debt Factoring

1. Disclosed and Undisclosed Factoring

Disclosed factoring is a type of factoring in which your customers are aware that you are using the services of a factoring company. The name of the factoring company is not indicated on the invoice you issue to your customers. 

Conversely, undisclosed factoring is a type in which your customers are not aware that you are making use of a factoring company: the name of the factoring company is also not mentioned on the invoice you issue to your customers. 

In such cases, the factor is responsible for managing the customer’s sales ledger, and the debt is collected on behalf of the firm. Nevertheless, the factor retains control over the process.

2. Resource Factoring and Non-Resource Factoring

In resource factoring, a company assumes the risk of non-payment of the invoice, and when a customer does not pay the factor, the company will have to buy back the debt.

Contrarily, in non-resource factoring, the factor assumes the risk of non-payment, and if a customer defaults, the company is not liable.

3. Domestic and Export Factoring

Domestic factoring is when the three parties involved in the factoring process, i.e. company, customer, and factor, reside in the same country.

While Export factoring, otherwise known as cross-border or two-factor system factoring is when there are four parties involved, i.e. the exporter (company), the importer (customer), the export factor, and the import factor, in the factoring process.

4. Spot Factoring

Spot factoring involves the singular sale of individual invoices to a factor, rather than selling the entire portfolio of accounts receivable. This type of factoring is used by small businesses or to finance a specific project. 

Advantages of Debt Factoring

  • It improves cash flow by providing immediate cash for the company. This will provide funds needed for investment, working capital, and other expenses.
  • By selling customers’ invoices to a factor, it helps the company to reduce non-payment bad debt risk.
  • Debt factoring makes your cash flow more predictable and makes business planning more accurate.
  • Since factoring improves cash flow, It boosts your company’s creditworthiness, and raising funds in the future becomes easy.

Disadvantages of Debt Factoring

  • It reduces the profit margin of the company. Since the factoring company takes a percentage of the value of the invoice as their fee for proving the cash upfront.
  • Is expensive compared to other forms of financing, such as bank loans.
  • If the factor is aggressive in dealing with the customers when collecting the debt, it can damage the relationship between the company and its customers. 
  • Factoring pays close attention to your customer’s portfolio and when they are seen as high-risk, it may attract higher fees for your company.

 Is debt factoring a long-term solution?

Debt factoring is a temporary solution companies usually use to enhance their working capital and address cash flow needs. However, in the case of businesses with a high-profit margin and a limited client base, debt factoring can be considered a viable long-term strategy.

Is factoring a debt?

Debt results in short-term indebtedness. Normally, this debt should be settled promptly upon the customers’ payment of their invoices. However, if the customers don’t pay, it can result in bad debt.

How does debt factoring improve cash flow?

Debt factoring helps businesses improve overall financial stability by avoiding the waiting period typically associated with invoice payments. The payment is made immediately by the factor that in turn gets the payment from your customers.

What are the charges for debt factoring?

The fees associated with debt factoring can differ based on various factors such as the size of the invoices being factored, the creditworthiness of the company’s customers, and the duration of the factoring agreement.

Typically, the fees for debt factoring can be categorized as follows:

  • Factoring commission: This is a percentage of the invoice value being factored in and may range from 0.5% to 5% per month. The specific rate depends on the aforementioned factors.
  • Service charge: This fee covers administrative expenses related to managing the factoring process, such as credit checks, debt collection, and account management. The service charge is usually a flat fee or a percentage of the invoice value being factored in.
  • Interest charge: This represents the cost of borrowing funds to meet immediate cash requirements. The interest charge is calculated based on the amount of cash received and the duration of the factoring arrangement.

It is important to mention that all of the fees mentioned can vary among different factoring companies.

Can a company factor all its invoices or some of them?

Yes, debt factoring allows businesses to selectively choose which invoices to factor in or factor in all of them. This financing option involves selling accounts receivables to a third-party factor in exchange for immediate cash, with the factor responsible for collecting payment from customers.

 A company might decide to factor all invoices for consistent cash flow, while another might selectively factor invoices for short-term cash flow needs. 

Whether to factor in all a company’s invoices or some of them depends on the goal of the business.

Bottom Line

Before a company decides to use a debt factoring service, it is important to know how it works, its advantages, and its limitations. This will facilitate structuring a good strategy before delving into it.

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