What Is Debt Factoring & How Does It Work?

From small to large businesses, understand how debt factoring can help you maintain a solid cash flo

Updated: February 12, 2024
Matt Crabtree

Written By

Matt Crabtree

 

Generally speaking, businesses of pretty much any size are going to find themselves in a period where work is a little bit slow, and their cash flow is beginning to suffer.

From your utility bills to paying any employees, any kind of disruption to your daily operations can put the financial health of your business under a degree of scrutiny — especially if you're a smaller business without the resources or connections to bail yourself out.

Fortunately, though, debt factoring (commonly referred to as accounts receivables factoring) can actually play a pretty crucial role here in keeping your business afloat during dry spells, so throughout this article, we'll be exploring this topic in a little bit more detail — covering how you can handle unpaid invoices and work with debt factoring companies.

Debt factoring probably sounds like complex financial jargon at the moment, but it's actually fairly easy to understand, so let's walk through how it can be a game-changer for any business owners who are trying to manage their cash flow.

What Is Debt Factoring?

To kick things off, it's worth providing a little bit of background information on the topic.

In essence, debt factoring is basically just a financial arrangement you can enter in order to manage your cash flow.

To be more specific, though, let's look at an example of what debt factoring looks like in practice. If you're a business owner who sells goods or services, there's a chance you've probably experienced one of your customers not making an immediate payment, which can obviously lead to issues pretty quickly if you were expecting them to pay more promptly.

If you want to get around this, there's the option of selling this unpaid/outstanding invoice to a debt factoring company instead of dealing with it yourself.

There's still more to unpack here, but the main takeaway here is that you'll be given a cash advance — usually tends to be around 70-90% of whatever the invoice value was — and they will then take all of the responsibility of collecting payment off your shoulders, dealing with your customer themselves.

Rather than being an incredibly courteous and charitable public service from the debt factoring companies, this is actually just their business model, as you can certainly expect to see plenty of fees with this line of credit.

Having said that, invoice factoring is still a very useful concept to be aware of if you're a small business owner and your customers pay fairly slowly.

How Does Debt Factoring Work?

With some of the key fundamentals of what debt factoring actually is out of the way, let's get into some of the specifics:

You Sell Invoices

As mentioned, you're probably issuing invoices to your customers in the normal course of any of your business transactions, which is especially true if any kind of credit terms are involved.

However, patiently waiting around for these payments can definitely cause a few issues when you're a small company — whether it's because you have fewer clients to cover their delay in income or you need a cash reserve to manage an unforeseen emergency.

So, rather than taking this route, a proactive choice would definitely be to sell any of the outstanding invoices you have to a debt factoring company instead.

Factoring Company Steps in

Following on from the previous point, the debt factoring company you're now working with will give your business a certain percentage of the total invoice amount as a cash advance, which is obviously a massive relief for anyone who was unprepared for a delay in a client payment.

In essence, you'll now be able to go about with any of your daily business operations and address any of the pressing financial needs you might've had without the wait.

Having said this, it's worth mentioning before going any further that depending on the debt factoring company that you go to, you'll most likely have to undergo a credit check in order for them to be sure you won't be a liability.

Secured loans don't apply in this particular instance, so if they do their due diligence and aren't satisfied by your creditworthiness, then there's a chance they won't handle your invoices from your customers, and you'll be left to your own devices.

Fees Get Deducted

Naturally, it would be too good to be true if the financial support you're receiving from these companies was without any kind of costs, so in order to compensate for some of their services, the factoring company will usually deduct a fee from whatever the remaining invoice amount is.

It's slightly complicated to give a one-size-fits-all answer in terms of how much this fee usually is, as it'll all depend on the company you've chosen — which is ultimately why it's so important to do your research and find an affordable debt factoring company if you decide to choose this route.

To be more specific, the fee structures across all companies tend to be influenced by a few different factors, whether it's your creditworthiness or more general industry standards, so you'll never normally be charged the exact same fee from two debt factoring companies.

Collecting Payment

At this point, you can catch your breath as the responsibility for payment collection is now totally in the hands of the factoring company, so this is naturally a huge stress reliever if your customers or clients are beginning to cause you some serious anxiety.

The debt factory company is now the one trying to chase down whatever the outstanding amount was from the customer — this includes things like sending your clients reminders and following up on any overdue invoices too.

Lastly, once your customer has finally settled the invoice, the invoice factoring company will deduct its fees and release all of the remaining funds straight back to you.

With the alternative being heaps of financial burden and unpaid employees or bills, it goes without saying that it can be an absolute lifesaver for business owners.

In addition, a slightly more subtle benefit here is that not only are you ensuring a smoother cash flow for your business, but you're also able to focus on all your core operations now instead of dealing with collections.

Advantages of Debt Factoring

Though we've only talked fairly positively about debt factoring companies and the impact they can have on your cash flow, we'd be doing you a disservice if we didn't also walk through a few of the disadvantages of debt factoring you can expect, too.

So, in this next section of the article, we'll be impartially breaking down some of the main pros and cons to see if this is still something you'd want to explore for your business.

Improved Cash Flow ✔️

Obviously, the main thing that turns heads with debt factoring is the opportunity to receive an immediate boost to your business's cash flow.

Every company will have their own things to choose from when you receive a cash advance on an outstanding invoice, so it's generally a great chance to address any short-term financial needs or concerns you might've had — whether that's covering operational expenses, paying suppliers, or even just seizing any growth opportunities you've found that requires an investment.

Efficient Management of Accounts Receivable ✔️

We touched on this a little bit earlier, but perhaps one of the more underrated parts of debt factoring and outsourcing the general task of collecting payments from your customers to a factoring company is the amount of time that you're saving.

Naturally, this means that you and your employees are able to go back to your main responsibilities instead of chasing up late payments from customers.

Aside from this, though, you're also opting for a much more efficient and slightly more professional approach to managing accounts receivable, and not only does this help you out in terms of organisation, but it makes you look good in front of your clients, too.

Access to Working Capital ✔️

Again, this is probably something that's going to provide a little bit more utility for the smaller businesses out there with seasonal or just fluctuating cash flow more than the established corporations, but debt factoring can be huge in terms of accessing a steady and reliable source of working capital for your company.

Whether you're going through lean periods or some kind of market opportunity pops up that you think is worthy of jumping on, this can obviously be a pretty crucial way of sustaining operations.

Disadvantages of Debt Factoring

Now that we've covered the benefits, let's explore some of the reasons why you might want to reconsider debt factoring and perhaps wait it out instead.

Of course, this might not be a luxury that's available to small businesses, but it's still worth covering both angles for a better perspective.

Debt Factoring Fees ❌️

Firstly, debt factoring obviously comes with the main benefit of immediately improved cash flow, but you're still going to have to deal with all of the debt factoring fees at some point.

Again, we can't be specific on how much these fees will be exactly, but they should still be a significant consideration if you anticipate you might not have the cash reserves to be able to afford it.

Generally speaking, it can definitely help your chances here if you have a fairly solid credit rating, but things like the total volume of invoices that you have to sell can make a difference in the cost, too, since you may be able to negotiate a deal for bulk quantities.

Potential Strain on Customer Relationships ❌️

We've talked a little bit already about how working with a factoring company that takes over the collection process can sometimes reflect positively on your business and demonstrate an element of professionalism, but this definitely has the potential to go the other way, too.

Of course, you'd like to think that the company you've reached out to has enough experience and quality to ensure your client is left with a positive impression, but there's always the chance for strained relationships between your business and its customers if you're not the one dealing with them directly.

Not everybody will care about this, but some customers might be a little bit unhappy with your lack of involvement, meaning the overall client experience can definitely be dampened a little bit if you're not careful.

Confidentiality Concerns ❌️

Depending on which industry you're in, you know there are times when you've got to be completely confidential with any of the financial arrangements you have with clients.

As you should be aware by this point, debt factoring means getting a third party involved in all of your business's financial dealings, so this can obviously lead to a few potential concerns regarding how securely kept their financial information is.

Ultimately, though, the debt factoring company makes money off their business with you, so you should generally expect them to adhere to non-negotiables you might have regarding a client's personal information.

Related Guides:

What Is Debt Factoring and How Does It Work: FAQs

How Are Recourse and Non-Recourse Factoring Different?

How Quickly Can a Business Expect to Receive Funds Through Debt Factoring?

Does Debt Factoring Impact a Business's Ability to Secure Traditional Financing in the Future?

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