Table of Contents
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 up front, 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.
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What Is Debt Factoring?
Debt factoring, also called invoice factoring, is when a company sells a percentage, often 70%-90%, of its unpaid invoices from its accounts receivable 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.
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How Debt Factoring Can Help Small Businesses Manage Cash Flow
Debt factoring is usually 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 their 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.
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Improving Financial Stability With Debt Factoring
One argument 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 their credit score and assets with a business loan if there’s a possibility they 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.
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Debt Factoring vs Small Business Loans
A major con 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 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? Could this hurt your relationship with them? Many debt factoring companies are 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 a better 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 are still in control of the invoice
• You won’t lose money in profits
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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.
Ready to grow your business? SoFi Small Business Loans can give you fast access to the capital you need. Check your eligibility 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.
Invoice financing, on the other hand, uses unpaid invoices as collateral, and you are still responsible for collecting payment from the customer.
What are the disadvantages of debt factoring?
A major drawback of debt factoring is 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.
What is an example of debt factoring?
A flooring company installed carpet for a 4,000-square-foot office building, but hasn’t received payment on the $28,000 invoice, causing working capital issues. To continue operations, it decides to utilize a debt factoring company that advances 80% of the invoice amount, equaling $22,400. However, they charge 5% of the total invoice for each week they are unable to receive payment, and over the two weeks it takes for the customer to pay, the factoring company keeps $2,800 of the $28,000 invoice.
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