Debt factoring, also known as invoice factoring, is a financial arrangement where a company sells its accounts receivable (i.e., its outstanding invoices) to a third-party factoring company. In return, the factoring company provides immediate cash to said company, which can then be used to pay suppliers, meet payroll requirements, or invest in growth. Debt factoring is a popular financing option for businesses that might be struggling to manage cash flow, or that might want to avoid the risks and costs associated with borrowing from traditional lenders.
How Does Debt Factoring Work?
To understand how debt factoring works, let us consider an example. Imagine that a small business has $150,000 in outstanding invoices that are due in 60 days. However, this business needs cash immediately to pay suppliers and meet certain other expenses. The business could sell its invoices to a factoring company and receive a percentage of the total amount, say 80%. The factor would pay the business $120,000 immediately and collect the full amount from the customers when the invoices are due. The factoring company would then pay the business the remaining $30,000, minus their fee.
Factoring companies typically charge a percentage of the invoice amount as their fee. These fees will vary from one factoring company to another, but they are usually between 1% and 5%. If in the case above the factor was charging 3% for their service, the fee would have been $4,500. So, when the invoices were paid, the factoring company would have kept the $4,500 and then paid the business $25,500 of the outstanding $30,000.
Advantages of Debt Factoring
The benefits of debt factoring are numerous. The main benefit is one mentioned above – it provides businesses with immediate cash that can be used for all sorts of purposes. This can be particularly important for those small businesses that do not have access to traditional financing options for whatever reason. Debt factoring also allows businesses to outsource the collections process. This frees up time and resources that can be used for other purposes. Additionally, debt factoring does not require collateral, so businesses do not need to put up assets as security.
Recourse and Non-Recourse Factoring
The experts at factoring company Thales Financial in Salt Lake, UT explain that there are two main types of debt factoring services – recourse factoring and non-recourse factoring. Recourse factoring means that the business selling the invoices remains liable for the debt if the customer does not pay. Non-recourse factoring means that the factoring company assumes the risk of non-payment. Nevertheless, non-recourse factoring is typically more expensive; additionally, it may not be available to all businesses.
How Much will Debt Factoring Cost
The cost of debt factoring is typically determined by the factoring company’s fees. Oftentimes, the fee is higher if the invoice amount is higher because the factoring company is advancing a higher sum. The amount that can be factored by a business will depend on several things including the creditworthiness of the customers, the size and age of the invoices, and the duration of the factoring arrangement. Factoring fees may include an application fee, a due diligence fee, and the factoring fee.
Debt factoring can be a valuable financing option for those businesses struggling to manage cash flow or that want to avoid the risks and costs of borrowing from traditional lenders. Some businesses need to factor their debts because they cannot access other types of funding due to having a limited credit history. By understanding how debt factoring works, businesses can make an informed decision about whether debt factoring is the right option for them.