Having the means to finance expansion, equipment purchases, or simply to ease the cash flow, is a high priority for any business. There is a range of capital raising options available to businesses, from bridging loans to commercial finance. While each option has its applications, there is another approach with more unique uses – debt factoring.
In this article, we will discuss debt factoring, its advantages, and its corresponding disadvantages. While the practice can certainly open doors, it has its pitfalls to be aware of. To make the right choice for your business, an informed choice is necessary.
What is debt factoring?
Debt factoring, more often referred to as invoice financing or accounts receivable factoring, is a method of financing that involves the sale of unpaid invoices for immediate capital. The invoices are sold to a third party, usually, one specialising in this form of finance. Such third parties are called factoring companies. Once the unpaid invoices are purchased, the business will receive most of the invoices’ value upfront, with a percentage being kept by the factoring company as a fee.
As debt factoring is essentially a transaction, selling your unpaid invoices for immediate cash, they are swift by nature. In a short space of time, your invoices will be off your desk and your pocket heavier. A valuable quality in any form of finance. Undoubtedly, this attribute of debt factoring alone can significantly benefit businesses, but there is much more to this capital raising method than speed. For a comprehensive dive into the advantages and disadvantages of debt factoring, continue on.
Advantages of debt factoring
- A speedy means to raise capital – Debt factoring is one of the quickest methods to put cash in your hands. After your application is approved, you can expect your money within as little as a day. Usually no more than two. This makes debt factoring an excellent tool for businesses needing capital urgently. For equipment, repairs, payroll, or anything else integral to your business’s operations. Additionally, the fast payout enables businesses to seize upon expansion opportunities, such as property purchases or acquisitions.
- Ease pressure on a strained cash flow – Cash flow is the be-all and end-all for expansion. A throttled cash flow constrains growth, holding back your business from what it could be. Conversely, a business with a more flexible cash flow can allow for investment into other areas. With the payroll covered and business costs paid, yet there is a surplus of capital, other facets of the business can gain. Debt factoring can make it easier to put your cash flow in such a state. Allowing you to invest in other areas of your business.
- Don’t worry about late repayments – No matter the industry, it’s a fact that some clients will pay their invoices later than others. Late payments are never a welcome sight, but for businesses with tight cash flows, this can be disastrous. With debt factoring, your unpaid invoices become the problem of the factoring company, and the profits go to you.
- Save on costs – As the unpaid invoices become the responsibility of the factoring company, you can place your or your employees’ efforts elsewhere. If you make regular use of debt factoring, you can save on employee costs altogether. You won’t have to hire someone to handle the invoices. Otherwise, you can simply invest time into areas more worthwhile.
- Quicken the speed with which you restock – When purchasing a shipment of goods, it often takes a considerable amount of time to see a return on the investment. The longer this takes, the longer you must wait to justify restocking, and, therefore, selling more goods. With debt factoring, you can acquire the necessary capital quicker. Allowing for a more sizable inventory, one that can be restocked with ease.
Disadvantages of debt factoring
- Successful applications rely on customer credit ratings – When applying for finance, it is most often your credit history that determines the likelihood of a successful application. As the factoring company is paid by collecting on your unpaid invoices, debt factoring bucks the trend. Instead of scrutinising your credit history, a factoring company will instead look to your customers. Too many with a poor record of payment, and it’s unlikely your application will succeed.
- Customer relations is at risk – While it is certainly convenient for another company to handle chasing invoice payments, it can come at a cost. Most factoring companies have a good standard of customer relations, understanding what goes into collecting payments. However, although the majority may be perfectly fine, there are some with a poor grasp of customer relations, which could reflect poorly on your business. After all, though factoring companies collect for themselves, your customers will still see them as your representatives.
- Some factoring companies lend with caveats – Understandably, factoring companies want to lend without taking on much risk. Any lender does. Where this becomes frustrating is in the conditions some companies will attach to their loans. Certain factoring companies will only lend to a business if it agrees to avoid risky practices. In such cases, risky will be up to them to define, potentially restricting you from engaging in practices that worked well previously. Moreover, the conditions can even extend to which customers you accept and whom you hire, particularly for leadership positions.
- Unpaid invoices can become your responsibility – Following on from risk mitigation, some factoring companies will foist any debts that go unpaid back onto you. This often means that you will have to pay the company the value of the invoice.
- Debt factoring can be expensive – Compared to more usual methods of raising capital, such as bank finance, debt factoring can be expensive. This is reflected in higher interest rates when compared to other forms of finance. In addition to this, fees charged by factoring companies can be higher than their equivalents for other types of loans. Usually, a factoring company will only charge high rates when a large number of a business’s clients are late payers. If your customers are slow to pay their invoices, it will likely be costly for you.
Conclusion
It is undeniable that debt factoring supplies businesses with a host of advantages. However, the same can be said for disadvantages. As with most forms of finance, the viability of debt factoring relies on your situation. For example, a business with a slow-paying customer base will find it more costly. Possibly making it a tough option to justify. Conversely, a business with clients punctual in their payments will benefit from a cash flow with much more breathing room. Something that could allow for growth and expansion. Equipped with the information in this article, you will be able to make an informed decision, and as such, the right decision for your business.