Debt factoring is a tool that every business should use to its advantage. What does debt factoring mean and how can it help your business? We're going to cover the multiple types of debt factoring, its advantages and disadvantages in this helpful guide.
A good debt factoring definition is the sale of a business's accounts receivable, at a discount, for immediate cash. The idea is that many companies have money tied up in invoices that are pending payment, and they need this money to continue their business operations.
Debt factoring, or invoice factoring as many businesses call it, is common in business. When clients or customers have not paid their invoices, you can use this financial tool to free up cash flow.
The perfect debt factoring example is, for example, let’s assume that you have $10,000 in a single invoice that will not be paid for 45 days. Your business needs this cash for operations and to pay employees.
Instead of taking out a loan or other form of credit, you decide that debt factoring is something you want to explore.
You'll need to take the following steps:
Depending on the factoring company, the “factoring rate” or “discount” will often be 1% - 5%. These terms can be much higher or lower. One of the advantages of debt factoring is that if you build a long-lasting relationship, you can often negotiate better terms.
So, when you sell the invoice at a discount rate of 1% - 5%, this means that you’ll receive $9,500 - $9,900 in cash. The factoring company will take the remaining amount as a fee for their services because they’ll need to push for the invoice’s payment.
At this point, the factoring company assumes full responsibility for the invoice and the risk of it going unpaid.
All types of debt factoring have their pros and cons. You should know that there are always a few disadvantages to these types of services. We're going to cover the most common benefits and things to consider below:
Cash flow will make or break a business. When you’re flush with cash, you have exceptional options. You can invest more into the business and take advantage of opportunities when you have cash.
However, money that is in an unpaid invoice isn’t liquid, so you cannot access it until the invoice is paid.
Services like these empower you by:
With debt factoring, you’ll save more time than just shortening the invoice payment time. You’ll also save time on collecting invoices.
Invoice collection can be a very time-consuming process. As a business owner, you have to:
When you sell the invoice, you reduce these burdens fully. Instead, you can get paid and be on your way. Invoicing companies will take on the burden of having to chase invoice payments or send out reminders.
However, you will still need to send the original invoice out.
Reducing time spent on the invoice process opens up opportunities for you and your business. You can spend the time saved working on core business tasks that will help you grow your operations.
Debt factoring gives you a lot of negotiating power, which many companies lack due to tight cash flow. If you’re making a deal with a supplier or vendor, you can negotiate better terms by paying in cash.
Cash payments are preferred in business, and you’ll find many suppliers will offer a cash payment discount.
Cash is king in the business world, and it will give you a lot of leverage in negotiations that credit will not allow.
Having steady cash flow also allows for faster business growth.
Let's find out.
Businesses must grow. Well, most businesses will want to grow their operations, while some choose to remain small to ensure that their operations aren’t too complicated. With that said, if you want to grow your business faster, you can do so with debt factoring.
Cash allows you to leverage opportunities that credit cannot. For example, cash will allow you to:
Additionally, cash allows you to maintain good credit terms, pay off debt or invest in your business. You cannot truly invest in your business without cash.
As you can tell, there are a lot of advantages of debt factoring. Your business may certainly need this type of service now or in the future. If you ever run into cash flow problems, you need options, and this is one option that you ought to consider.
However, we also have to discuss the disadvantages of debt factoring so that you know if this is a good opportunity for you.
Debt factoring is one of the opportunities that you’ll have to turn invoices into cash. However, there are some disadvantages, which you may have already determined on your own with the example we provided previously.
The main disadvantages of this practice are:
Profit margins are crucial to your business’ success. If you have profit margins that are too low, you’ll end up running into cash flow problems. The issue is that you when use debt factoring, you’re reducing your overall profits.
In the previous example, you will lose $100 to $500 on an invoice, and this figure may be even higher.
From a profit standpoint, if you make 20% profit, you’ll be making more like 15% profit if you sell the invoice at 5%. As you can see, the more that you engage in invoice factoring, the less profits you’ll have.
Factoring shouldn’t be the only steps that you take to improve cash flow. Instead, you also need to take additional steps, such as:
If you do not address the issue above, cash flow will remain one of the biggest obstacles for your business. You may even end up with severe debt or have to close your operations if you do not work on improving cash flow.
Debt factoring companies want you to have higher cash flow, and the reason that businesses rely on them is because they’ll pay for the invoice quickly. In most cases, the factoring company will provide:
Immediate cash upfront for invoices will alleviate most of your issues with cash flow. The cash in your account will also allow you to stay out of debt, make payments on time and maintain strong relationships with employees and vendors.
One of the ways to improve cash flow is to use software to manage cash flow. Business owners have a lot of responsibilities, and it’s easy to overlook issues with cash flow when you have to:
Simple software can help you make sense of your cash flow by crunching the numbers for you. In fact, you can even “make money,” or really save money, by using the right software solution.
Cash Flow Frog is the best cash flow forecasting software on the market, and it can help you “make money” by reducing the need to sell invoices at a discount or take out loans or credit at high interest rates.
Instead, Cash Flow Frog provides you with the tools to:
One of the main issues that businesses face is that they do not spot cash flow issues until it’s too late. With a tool like Cash Flow Frog, you always have access to your cash flow statements and can use the platform to make smarter decisions about the future of your business.
Debt factoring is one tool that your business should use if you have accounts receivable that are unpaid. The option to sell the invoice and get immediate cash can help your company remain financially healthy.
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