Debt Factoring: Meaning, Pros & Cons

Debt factoring is a practice that has increased by nearly 10% each year over the past five years. If you’re running a business or handling accounting and cash flow remains an issue in your company, it may be worth learning the:

• Debt factoring meaning
• How factoring works
• Trade credit advantages and disadvantages

We’re going to explain all of these points in the guide below.

Before considering whether or not this type of financial vehicle is right for your business, it’s important to learn what it is.

What is Debt Factoring?

Debt factoring is an intuitive way for you to keep money in the bank instead of in accounts receivable.

A good debt factoring definition is: selling your accounts receivable to a third-party for a portion of the invoice’s value.

For example, let’s assume that you:

• Finish an order for $10,000
• You send the invoice to the company
• 30 days have passed, and the invoice remains unpaid

You have $10,000 in potential liquidity that you cannot use to grow or operate your business. What can you do? You can use invoice factoring services.

Working with a debt factoring company works something like this:

• You sign up for an account
• You work with a manager
• Send the invoice to the company
• They'll check the credit of the company that has yet to make payment

If everything checks out and the risk of non-payment is minimal, the factoring company will purchase the invoice at a discount. Based on the example above, the agreement may be that the company pays 90% of the value outstanding or $9,000 to purchase the invoice.

The debt is then transferred to the factoring company, which will be responsible for seeking payment.

Factoring companies will keep the $1,000 in reserve and often charge a percentage each week until payment. In this example, let’s assume a 1% fee per week is charged while they chase payment, and the payment is made after 4 weeks.

You will receive $600 (1000 – 400) from the company, and they’ll keep $400 as their fee.

The Significance of Debt Factoring

Debt factoring is significant for many businesses. Trucking companies are a prime example of when factoring may be most powerful. For example, many truckers are left waiting for invoice payments, yet they have to cover fuel and maintenance costs for their vehicles.

Factoring allows you to:

• Speed up payments
• Offload debt collection
• Operate without piling on debt

Cash flow is the most important metric in any business. You can have 1000% growth and still be running at a loss that forces business closure because you don’t have adequate cash flow to cover expenses.

Debt factoring advantages and disadvantages must be considered before you begin selling your first invoice.

The following advantages of debt factoring are why every business should at least consider using one of these services:

Improved Cash Flow Management

Cash flow management and debt factoring advantages are intertwined. In the trucking industry, it’s common for owner-operators to sell their invoices for 1% to 5% of the total value. Businesses may opt to sell for a few reasons:

• Payment is late and they can no longer wait for cash
• Surprise expenses materialize and they need cash

Rather than taking out a loan, invoice factoring can help a company cover payroll and expenses without needing to add debt to its balance sheet.

For cash flow management, debt factoring is a great opportunity to keep operations running smoothly.

Focus on Core Operations

Tracking down debt and being paid takes massive time and resources. Imagine running a single-person business and needing to spend 4 hours for each invoice to contact accounting teams and demand payment.

Selling the invoice at a discount allows you to:

• Focus on your business’s core activities
• Avoid wasting resources on receiving payment

One of the advantages of invoice discounting is that business owners and accounting teams can focus more on growth initiatives rather than spending time on securing payment.

Fast Access to Funds

Sometimes, business is all about timing. You may have an opportunity to acquire a competitor today and not tomorrow. You may be able to market a new product today and be the first to market it, but if you lack cash flow, a competitor can beat you to it.

Speed and timing of funds are why many companies use debt factoring.

Capital infusions are one of the main advantages of factoring that allow you to:

• Take advantage of timely opportunities
• Avoid taking on debt to cover expenses
• Keep running your business without interruptions

Fast access to funds is always a great asset when operating a business. You can never have too much cash liquidity because it will empower you to secure lower prices, pay lower fees and invest in time-sensitive opportunities.

There are many advantages and disadvantages of factoring, but it’s important to really weigh the cons carefully.

Some of the potential drawbacks of debt factoring include:

Costs and Fees

Debt factoring does come at a cost, and that cost can be high in some cases. Typically, factoring companies will advance you a percentage of the invoice (85% to 90% usually) and hold onto the rest. They will charge a fee (usually 3%) for every 30 days it takes for the customer to pay the invoice.

The cost and fees are one of the biggest disadvantages of invoice discounting and can have a negative impact on your company's financials.

Customer Relationships

Another potential disadvantage of factoring is that it may damage your reputation and relationships with customers.

The factoring company will be in charge of collecting invoice payments, and they will have their own methods for doing so.

Customers will know that another party is attempting to collect on the invoice, which can make a bad impression.

Understanding the factoring company’s collection practices can help ensure that it won’t provide a negative customer experience.

Qualification and Eligibility

Every factoring company will have its own eligibility requirements, but generally, you will need to demonstrate that:

• You have creditworthy customers
• You generate a certain amount of dollars in sales per month
• Customers are given at least 30 days to make payments

Typically, it’s easier to qualify for invoice factoring than a conventional loan, but you will still need to meet certain requirements to be approved.

Knowing these requirements ahead of time can help you prepare for your application.

The main advantage of factoring is that your business gets the cash infusion it needs. But you must take the potential disadvantages into account if you want to make an informed decision.

When determining whether factoring is right for your business, keep the following points in mind.

Assessing Your Business Needs

First and foremost, consider your business’s needs.

• Do you need to bridge a temporary, urgent cash gap, or is there a long-term issue with your cash flow?
• How much cash do you need? Invoice factoring will be limited to the value of your invoices.

Additionally, consider how quickly clients pay their invoices. It may not be worth losing a percentage of the invoice if clients pay relatively quickly.

Create a framework for evaluating whether your business needs invoice factoring to help ensure you’re making the right decision.

Making an Informed Decision

Debt factoring is a simple and quick way to infuse your business with cash, but it’s also expensive. For this reason, it’s important to weigh the pros and cons very carefully before making your final decision.

Many businesses find that invoice factoring only makes sense for temporary cash flow problems and should be viewed as a short-term solution.

Debt factoring is one of many solutions for businesses that need to bridge cash gaps. Understanding how it works, its advantages and its disadvantages can help your business decide whether invoice factoring is the right choice.