Debt factoring is another word for accounts receivable finance or the process of selling unpaid invoices for a percentage of their worth.
It is a useful form of alternative finance designed to support the working capital cycle.
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How Does Debt Factoring Work?
A company may choose to factor a portion or all of its invoices. First it approaches the ‘factor’, a financial institution or lender who specialises in accounts receivable finance.
The factor assesses the level of risk by looking primarily at the financial health and reliability of the companies owing the invoices. Based on this analysis they then make a quote regarding what percentage of the invoices they can factor (up to 90%), and the terms are drawn up.
Once the agreement is signed, the lender advances most of the money straight away with a small proportion held back until the invoice has been paid.
- Speeds up the working capital cycle
- Saves time and administrative resources
- Can speed up growth
- Non-recourse factoring protects you against bad debts
- Higher interest rates than traditional bank loans
- May damage confidence in your business as your clients become aware of the factoring
- Unless specifically arranged, factoring is with ‘recourse’ which means you will be liable to cover any invoices which aren’t paid.
- Won’t work if your clients have adverse credit history
- The slower your customers pay the higher the factoring fees
What is a Typical Charge for Debt Factoring?
The costs of debt factoring are dependent on the size of the invoices, the credit history of your clients, the industry you work in and the overall stability of your own business.
Factoring comes with two basic charges: the advance (which is the percentage of the amount you’re given up front) and the rate (which is the cost of financing.)
Rates vary from around 1.5% to 4% per 30 days, which advances averaging around 75-85%.
How Does Debt Factoring Improve Cash Flow?
Once the factoring arrangement is in place, businesses no longer need to wait anxiously each payment cycle for customers to settle their invoices. With the debt factor paying the advance on the same day each month, businesses can benefit from assured cash flow which leaves more time for them to do what they do best.
Especially useful for businesses with a smaller number of invoices at a higher value, and where the profit margin is healthy, factoring can transform the day to day running of a company.
What are the Risks of Debt Factoring?
If you have understood the fees (and ensured no hidden costs, charges or exit fees, the main risk of debt factoring is that when a customer doesn’t pay and you have already received the advance, you will become liable for that debt.
You can mitigate a lot of these risks by choosing a respected and trustworthy factor and only using it when necessary.
Many businesses do run for years with factoring in place without issue.
Is Debt Factoring Long Term?
Debt Factoring usually exists as a short-term cash flow measure for businesses that want to increase their working capital cycle.
However, in certain situations – for example, where a business has a high profit margin and relatively few number of clients – factoring may well continue long term. In that scenario, profit margins mean that the factoring may be considered an acceptalble