Many businesses use debt factoring to help maintain positive cash flow. If you’re considering using debt factoring, it’s important to understand what it is, how it works and the pros and cons.
So, what is debt factoring, exactly? Debt factoring is another term used for invoice factoring. It’s a form of short-term financing in which a business sells its accounts receivables at a discount to a third party.
· The business receives a percentage of its receivables upfront.
· The third party assumes the responsibility of collecting the payment from customers.
· The payment is collected, and the business receives the difference, minus the third-party’s fees.
With debt factoring, businesses get access to the capital that’s tied up in invoices right away. Quick access to capital means that businesses can maintain positive, healthy cash flow.
Debt factoring is a straightforward process:
· A factoring company buys a business’s outstanding invoices at a discount.
· The business gets paid a percentage of the invoices upfront. Let’s say that you have an $80,000 invoice and the factoring company will advance 90% of the invoice. You would receive $72,000.
· The factoring company will then charge a factoring fee, typically 1% of the total invoice amount, every week until the customer pays. So, 1% of $80,000 is $800. If it takes three weeks for a customer to pay, you will pay $2,400 in fees and receive $5,600 in return.
In this example, you would receive 97% of the invoice’s value, or $77,600 total. The factoring company would receive $2,400 in fees.
There are advantages and disadvantages of debt factoring. These benefits and drawbacks should be considered carefully when deciding whether this form of financing is right for your business.
There are several advantages of debt factoring, including:
Steady Cash Flow
One of the biggest advantages of debt factoring is being able to maintain steady cash flow. If you’re using a tool like cashflowfrog.com for forecasting and cash flow management, you can predict potential cash flow issues in the future.
Debt factoring can help you stay afloat during these periods or avoid them entirely.
But how does debt factoring improve cash flow?
Rather than having to wait for customers to pay their invoices, you get access to this cash immediately, which will improve your cash flow.
Quick Access to Capital
With debt factoring, you get quick access to capital that you can use for payroll, everyday expenses or even to invest in a new business opportunity.
Factoring companies can provide capital in as little as 24 hours.
Generally, it’s easier to qualify for debt factoring than other financing options, like traditional loans.
Factoring companies tend to focus more on the reputation and creditworthiness of the customers rather than the business itself. For this reason, debt factoring can be a great option for startups.
Because the financing is backed by your invoices, factoring companies don’t typically require any physical collateral.
Another big advantage of debt factoring is that you don’t have to spend time collecting payments from customers. Rather than chasing down customers for payments, you can focus your time on running your business and finding ways to make it grow.
While there are many benefits to debt factoring, there are also some drawbacks that need to be considered, such as:
No Control Over Payment Collections
Some business owners feel that debt factoring has a negative impact on their relationships with customers. However, having an understanding of the factoring company’s collection method can put the owner’s mind at ease.
Researching the company first can help you determine whether its collection methods are ethical.
The biggest drawback of debt factoring is that it reduces your overall profit because you don’t receive the full invoice amount.
Factoring fees can range from 1%-5%, so depending on your business, you may lose a significant amount of profit with this type of financing.
Debt factoring isn’t a good option for every type of business. This type of financing can only be used with businesses that send invoices to clients.
If your business sells products or services to consumers, you’ll need to find an alternative option for financing.
Even if your business can use debt factoring, that doesn’t necessarily mean that you should.
If you’re looking for a short-term financing option and you have cash tied up in invoices, debt factoring may be a good option to help maintain cash flow.
But it’s important to remember that this form of financing is costly.
Debt factoring can provide a business with quick access to capital when they need it. While there are drawbacks that should be considered, debt factoring does have its place and can help a business avoid cash shortages.