What is Debt Factoring?
Debt factoring involves selling accounts receivable or unpaid customer invoices to a debt factoring provider – a ‘factor’. The factor then owns the debt and chases payment from the customer.
A typical arrangement would be that the factor pays around 80% of the value of the invoices for factoring. Once the customer pays the factor, the factor will pay the remaining 20% to the business, less their provider’s fee.
Given that customer credit is based on net-30, net-60 or net-90-day terms, it is one, two or three months before a business is paid for its work (and that is when customers pay and pay to terms). Factoring improves cash flow by assuring invoice payment much sooner.
Two types of factoring
Non-recourse factoring is typically and unsurprisingly more expensive. The factor will also be far more interested in a customers’ creditworthiness, as the return it makes will be massively affected by being paid by customers of the business that is factoring its debts.
Factoring fees are known as a discount rate and are typically between 0.5% and 5% of the invoice value per month. The discount rate is charged either weekly or monthly, so the longer it takes a customer to pay, the higher the total factoring cost.
The cost of factoring will be more than a conventional loan when the annual percentage rate (APR) is calculated, but there is a difference in the total cost because in factoring you are borrowing the cash for such a short period of time.
Risks of debt factoring
- Some small businesses can become reliant on debt factoring to finance its working capital long-term, and as set out above, it is a more expensive way of borrowing.
- Collecting debts involves interaction with customers and in factoring its debts the business has handed this over to a third party – the factor. This runs the risk that a factor only focuses on collecting the cash rather than treating the customer as a customer.
- In some cases, there may be a big advantage to handing this part of the process to a third party that is simply interested in debt collection. It may make sense to use factoring for some customers and not others, if this is an option.
Advantages of factoring
- For a small growing business, credit control and managing and chasing up invoices can be expensive. Debt factoring can free up constrained resource to be used elsewhere in the business.
- A healthy growing business needs working capital to ensure smooth operations. Where sales are regular, debt factoring does provide smooth availability of cash flow to fund operations. It may prove sufficient for investment in plant & equipment, although for larger items of capital expenditure specific (cheaper) loans would be more appropriate.
Philip King, Small Business Commissioner