Debt factoring is a way for a business to raise money quickly and improve cash flow by using its accounts receivables as leverage. This involves selling unpaid invoices to a debt factoring company for a fee in return for an instant injection of cash of up to 90% of the invoices value. The debt factoring company will, in most cases, take on the responsibility for collecting payment of the invoices from the buyer and once payment is received in full will pay the business the outstanding amount of the invoice minus its fee.
Many small to medium businesses struggle to manage cash flow and it can become an issue. Sales may be high but if the waiting time for cash to be received from unpaid invoices is lengthy and doesn’t correspond with when working capital is required then problems can occur.
As it can be a popular form of finance for small to medium businesses, it’s worth being aware of the main advantages and disadvantages.
Advantages of debt factoring:
- Improves cash flow: Cash is received as soon as the invoice is sold allowing for better control over investment and growth decisions and therefore improved business operations. Any short term financial issues can be smoothed over with this quick injection of cash which in some cases can enable a business to survive.
- It's a quicker way to obtain financing: Unlike other business loans debt factoring provides cash quickly reducing the need for overdrafts or a reliance on other debt facilities.
- Saves time and resources: Freeing up time is partly facilitated by the improvement to cash flow but also from freeing up the resources that are required when chasing up unpaid invoices. The time and resources saved can then be used to run the business more efficiently, directing more energy towards growth and improved operations.
- Accelerates growth: If the money received from the debt factoring company is invested wisely it can lead to better growth. As growth improves with time and the business is able to build a strong customer base with more funds available it may be able to reduce its reliance on debt factoring.
- Improves negotiation: Suppliers can be paid quicker as cash from invoices is received sooner allowing for improved terms to be negotiated.
Disadvantages of debt factoring:
- Overall profit is reduced: A fee of around 1-3% of each invoices value is charged therefore the profit made on each one is reduced.
- Loss of control over sales ledger: As the debt factoring company takes over responsibility for chasing payments of invoices the business lose some control over its sales ledger, there is also a loss of confidentiality. Customers will often be credit checked and customers will be aware that the service has been outsourced, this may affect customer relations.
- Short term debt: Whilst debt factoring has many benefits it puts the business into short term debt. If the invoice isn’t paid by the customer on maturity to the debt factoring company or there is a dispute, the borrower is in debt to the financer. It is important to agree who pays for an unpaid invoice.
- A solution to cash flow limitations only: If a business’s funding requirements are different it will be advisable to look to other forms of finance.