What It Is and Is It Right For Your Business
Every business understands the importance of a healthy cash flow. We also understand how difficult it can be to maintain that healthy flow. With the pandemic wreaking havoc on the economy this past year, cash flow has been a hot topic for every business of every size. Debt factoring has been in conversations and is gaining momentum by the moment. Before you jump on board, you need to understand what it entails. This article will explain what debt factoring is, the advantages and disadvantages, and how it can help your business.
Business owners always seek out ways to leverage their assets. Debt factoring is a specific form of financing designed to help partners and managers reach short-term business goals and obtain funding without a loan. Debt factoring is based on selling accounts receivables to an entity that pays a fee for those accounts receivables. The third-party entity offers the seller a percentage of the total value of the accounts receivables.
It enables businesses to obtain convenient access to funding before the customers pay for the services or goods they received. Debt factoring is sometimes referred to as invoice factoring or invoice financing. Debt factoring, perhaps more commonly known as invoice factoring, is a form of business financing in which business owners sell their unpaid invoices to a third party, typically called a factoring company, in exchange for most of the value of the invoices in advance of customer payment.
Unlike invoice discounting, also called invoice financing, debt factoring involves the sale of a business’s accounts receivable, as opposed to borrowing money against your invoices. In addition, when you enter into a debt factoring agreement, the factoring company then becomes responsible for collecting payments on your invoices from your customers. With fast access to capital and flexible qualification requirements, debt factoring is a popular way for B2B and service-based businesses to mitigate cash flow issues.
Defining Debt Factoring
Debt factoring is the act of selling your unpaid invoices to get cash now without waiting on your customer. It is sometimes known as accounts receivable factoring and sounds like a fast way to get your money. It is a little more in-depth than a simple sale of customer invoices. Let’s look at how Debt factoring works.
Debt factoring is a loan of sorts. You choose the factoring company and bring the unpaid invoices that you wish to get paid. There is an approval process and if everything checks out, you move on to the factoring agreement, then payment. The lender will pay you a percentage of the invoice value, often 80-90%. The customer who owes the invoice will make the payment to the factoring company. They will pay you the remaining percentage, less factoring fees, and an annual percentage rate (APR). You may find lenders who will cover 100% of the invoice value but those companies often have higher fees and APR. The money you receive can cover any business expense you have, from buying more inventory to paying utility bills.
How Debt Factoring Works
Debt factoring features three entities: a debt factoring company, a client, and a business entity. The factoring company (factor) purchases the accounts receivable invoice from the business entity. The client then pays the factor as the invoice comes due. A factor may be a financing company or an investor. The client is the individual or company who purchased the service or product. The client is obligated to pay the factor for the service or good. The business sells services or goods. Businesses allow customers to pay for services or goods at a date after receiving the services or goods.
Factoring companies typically charge their fees as factor rates (also called discount rates or factor fees). These fees normally range from 1% to 3% of the value of the invoice(s) and are charged for each week that it takes for your customers to make their payments. In addition, some companies will charge a processing fee at the point of sale. This being said, as we mentioned briefly above, after you’ve sold your invoices to the factoring company, that company then becomes responsible for collecting on those payments—one of the biggest differences between debt factoring vs. invoice discounting. Overall, because invoices often have net terms of 30, 60, or 90 days, debt factoring gives you access to capital that it may take weeks or months to receive otherwise—thereby freeing up your cash flow for use in your business.
Advantages Of Debt Factoring
So far, debt factoring services sound like a great way to help a business move forward. The advantages of invoice factoring can really save a small business from closing its doors permanently. Here are a few reasons why a business will consider a factoring arrangement.
Staying on top of invoice tracking and payment collection can require extra time that you may not have. Especially if you are a business that had to downsize this past year, leaving your small team spread thin. With many folks working from home, it is easy to lose track of an invoice here and there. It is also important for those companies looking to expand but don’t have the manpower to handle the expansion and tracking down funds. Debt factoring gives the lender the job of tracking and collecting payments, while you take care of other things happening in the business.
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Healthy Cash Flow
Obviously, the biggest advantage is having an immediate cash flow that works for you. If you can’t wait 30, 60, or 90 days for payment, this is going to be the most attractive aspect to moving forward with debt factoring. You can get your money fast from a factoring company and pay your bills, payroll, and buy necessary supplies and inventory. You won’t be sitting back trying to juggle getting paid and paying your own bills. When companies are juggling too much, that is when late fees and penalties come into play and hurt the financial snapshot.
Expand Your Business
Not every business is suffering to the point of needing debt factoring. Some businesses want to expand their services or product lines but don’t have enough working capital to do so.It is a tough spot to be in when you need to grow but you feel your hands are tied. Increasing your cash flow can get you fast access to capital and catapult your business into a new playing field. Expand your product line, add more services, improve your e-commerce, and hire more people to help you move forward. A growing business can really thrive with quick cash.
This option can be very affordable if your clients pay their invoices on time. While this won’t always happen, if you sell the invoices of your reliable clientele, you won’t have to pay more than the minimal fees. Some factoring lenders will offer lower APRs to companies who have used their services and proven to have reliable clientele. So if you need to come back and use the services again, you could potentially save a lot more than with a traditional loan.
Disadvantages Of Debt Factoring
Just like everything else in life, there is a risk with any choice you make. There are significant downfalls to using debt factoring that is important to understand. If anything sounds too good to be true, it often is. While debt factoring is helpful, these are the risks you need to take into consideration.
Credit-Worthiness Is A Factor
You may think you can walk into a factoring company and hand over some invoices but there is more to it. The company is going to check your clients’ credit ratings before approving them for payment. They are a lending company so they want to ensure that they will get paid. They do not want to risk anything going into collections. Late payments complicate matters but you will pay for those late payments. Even if your client pays you on time every month, if they are not creditworthy, it won’t be approved. Given how the past year has gone, a lot of credit lines are being paid late and dropping credit scores.
Customer relations can be strained when using a debt factoring lender. If payment processing has gone wrong, your customers don’t talk to you. If they have a dispute about the invoice, they don’t talk to you. They will have to discuss everything with the lender. Relationships with your customers can suffer when they have to talk to a third party who doesn’t know them. Y cannot offer invoice discounting for early payment or the removal of late fees out of compassion.
Many business owners also struggle with the idea that if their customers know they are working with a factoring company, that there is an assumption the business is in crisis. No one wants to give their customers the idea that they are not doing well, it can lead to customers finding a new business to work with. Relationships are everything to a successful business so this is one of the top reasons to consider when deciding on debt factoring.
The reality is, you will lose some of your money by selling your unpaid invoices. Yes, the quick cash can help you get through, but you are sacrificing a portion of what you have earned. There are fees and then there is interest. Even if every customer pays the invoice on time, some of it goes to the lenders. Customers who aren’t paying and are considered bad debt will cost you even more. That also leads to a possible loop of financial stress that leads to dependency.