Debt factoring describes a situation when a business works with a third party company to receive payment on unpaid invoices. The debt factoring company usually buys the invoice at a discount and provides the remaining amount once it is able to collect payment.
As you may expect, there are fees involved, but if you’re having working capital issues, debt factoring may be a viable solution.
Key Points
• Debt factoring, or invoice factoring, is a financial arrangement where a business sells its unpaid invoices to a factoring company at a discount, providing immediate cash flow rather than waiting for customer payments.
• The factoring company pays the business a percentage of the invoice value upfront, usually 70-90%.
• The remaining balance, minus fees, is paid once the customer settles the invoice.
• Debt factoring improves cash flow, reduces the burden of chasing payments, and allows businesses to access working capital quickly for day-to-day operations or growth.
• The factoring company charges fees, typically based on the invoice value and the duration until payment, which can make it more expensive than traditional loans over time.
• An alternative to debt factoring is small business loans, which tend to come with fixed monthly payments and larger loan amounts. Small business loans also don’t affect your relationships with your customers.
Recommended: What Is Insolvency?
What Is Debt Factoring?
Debt factoring, also called invoice factoring, is when a company sells its unpaid invoices from its accounts receivables to another company at a discount. The remaining amount is paid once the third party company is able to collect payment, minus any fees it charges.
Companies that make use of debt factoring often do it to shore up working capital issues. With debt factoring, they may be able to cover all of their operational expenses and make payments on their short term debts.
Keep in mind that traditional small business loans may be a better fit, especially when it comes to working capital.
Recommended: 15 Types of Small Business Loans
How Debt Factoring Can Help Small Businesses Manage Cash Flow
Debt factoring is best utilized as a boost to working capital. Companies that are having liquidity issues because of cash stalled out in accounts receivable can use debt factoring to help pay for any of its operating expenses and short term debts. While there are fees involved with debt factoring, the benefit of it is that the money obtained from it can be used to fund incoming orders and jobs. In other words, it can help keep business moving.
Business owners strongly considering debt factoring should take the time to compare companies and fees. Each business charges differently for its services, so it is possible to save money by working with a different company.
Recommended: How to Build Business Credit
Improving Financial Stability With Debt Factoring
One of the strongest arguments that can be made in favor of debt factoring is that businesses are not taking on additional debt to rectify cash flow issues.
Businesses having issues with working capital may not want to endanger its credit score and assets with a business loan if there’s a possibility it won’t be able to make the monthly payments. By working with a debt factoring company, they are keeping their finances relatively the same. For many small businesses, including new ones, this may be enough of a reason to work with a debt factoring company.
On the flip side of this argument, just remember that you are losing a small percentage of the invoice to the debt factoring company through fees. While debt factoring can certainly help with working capital, you are reducing your overall profit each time you do it.
Recommended: Small Business Startup Loans
Debt Factoring vs Small Business Loans
One of the biggest cons to debt factoring is that it reduces a company’s profit because of the fees charged by the third party. Companies vary on what they charge, but a common fee is to charge a small percentage of the invoice amount for each week they are unable to receive payment.
Depending on how ethical of a company they are, this may disincentivize them to pursue payment from your customers right away. Plus, many debt factoring companies charge other fees, such as ACH transfer fees or account management fees.
The next thing you want to consider is customer perception. While some of your customers may not make their payments in a punctual manner, how will they feel knowing their account was essentially sent to a collection agency? Will this hurt your relationship with them? Many debt factoring companies are 100% professional and ethical, but some may not transmit that image.
Before deciding which company to work with, make sure you read plenty of customer reviews.
Another thing to consider is that debt factoring isn’t ideal for every company. Many businesses simply don’t revolve around invoices. For these companies, a small business loan may be the best option.
If you are considering debt factoring to solve your working capital issues, a small business loan may be a better fit. Benefits of small business loans include:
• You may save money in fees
• You may be able to borrow a larger sum of money
• It won’t affect your company’s image
• You will still be in control of the invoice
• You won’t lose money in profits
Recommended: What Is the Minimum Credit Score for a Business Loan?
The Takeaway
Debt factoring allows a company to sell its unpaid invoices to a third party company at a discount. That company is then responsible for collecting payment. Once payment is received, any remaining invoice amount is forwarded to the business minus any fees.
While there are certainly benefits to debt factoring, it may make more financial sense to pursue a small business loan. Not only may you be able to borrow a larger amount, but you might also save money in fees.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
What is the difference between debt factoring and invoice financing?
With debt factoring, you sell the invoice to a third party company at a discount and it takes control over collecting payment from the customer. Debt factoring companies typically charge a weekly fee for each week the invoice is unpaid. While responsibility falls on the debt factoring company, it’s the small business that is penalized.
Invoice financing, on the other hand, uses unpaid invoices as collateral. You are still responsible for collecting payment from the customer. Once your customer pays, you use the money to pay off the loan. Some business owners may prefer it over debt factoring because they keep total control over their company’s image.
What are the disadvantages of debt factoring?
The biggest drawback of debt factoring are the fees, which can eat into your company’s profit. Also, because you are no longer in control of securing payment, your company’s image may be sullied by the third party company. If you need the invoice for working capital, a short term small business loan may make more financial sense. You may pay less in fees and may be able to borrow a larger amount.
What is an example of debt factoring?
A company installed carpet for a 4,000 square foot office building, but has yet to receive payment on the $28,000 invoice. Because the project used up so much inventory, they are now having working capital issues. To rectify this so they can continue operations, they decide to utilize debt factoring.
The debt factoring company gives them 80% of the invoice amount, which equals $22,400. However, they charge 5% for each week they are unable to receive payment. It takes two weeks for the customer to pay, which means the factoring company keeps $2,800 of the $28,000 invoice.
Photo credit: iStock/PeopleImages
SoFi's marketplace is owned and operated by SoFi Lending Corp. See SoFi Lending Corp. licensing information below. Advertising Disclosures: SoFi receives compensation in the event you obtain a loan through SoFi’s marketplace. This affects whether a product or service is featured on this site and could affect the order of presentation. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider.
This content is provided for informational and educational purposes only and should not be construed as financial advice.
Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.
Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.
SOSMB-Q424-090