Maintaining positive cash flow is crucial for keeping your business afloat. But when you have to wait 30, 60 or even 90 days for payment, this can hinder your ability to pay bills and other necessary expenses on time, adding unnecessary stress to your plate as a business owner.
Imagine how proactive you could be in growing your business if you could immediately access cash tied up in unpaid invoices. This is where debt factoring comes into play.
Debt factoring is a business finance solution that can free up working capital without taking on debt. This blog explores debt factoring, how it works, and its advantages and disadvantages so you can see whether this cash flow solution suits your business.
What is debt factoring?
Debt factoring, also known as invoice factoring, is a way for a business to sell its unpaid customer invoices to a debt factoring company to access cash instantly. The factoring company will collect the payment from the customer themselves when the invoice is due, i.e. in 30 days.
The cash you receive from the debt factoring company is an advance on your impending invoice payment. Once the customer pays the factoring company, they take their fee before sending you the remaining invoice balance.
How does debt factoring work?
The debt factoring process can be split into just four steps:
- Choose which unpaid invoices you want to ‘sell’ to the factoring company. This can be just one customer invoice or multiple.
- You’ll receive an advance of up to 95% of the unpaid invoice amounts in just days from the factoring company. This money is yours to do with as you please.
- When the invoice is due, the customer pays the debt factoring company instead of you.
- Once customers pay the invoices in full, the factoring company sends you the remainder of the payment minus their fees, which can be between 1– 5%.
The advantages of debt factoring
There are several benefits of debt factoring; here are just a few.
- Quick access to cash. With the debt factoring company advancing you the majority of your unpaid invoice, you can enjoy an immediate cash injection. Use these funds to hire new staff, pay rent, purchase inventory, or save it.
- It’s not a loan. Although debt factoring is a financial arrangement, it’s not a loan; they’re just fronting you your money. This means you don’t owe anyone any money. You’re accessing money owed to you just a little earlier.
- No more chasing invoice payments. The factoring company takes over the role of credit controller. This means you don't have to manage any of the debt collection; it’s all done for you, so you can focus on running your small business instead.
- It’s flexible. You don't have to sell every invoice to your factoring company. Instead, select the invoices you want to release cash on. This flexible approach means you're in control of your cash flow.
- Quicker business growth. By accessing cash quickly, you can take calculated risks to grow your business as you have a more predictable cash flow rather than waiting for the full invoice payment period. Invest in that marketing campaign or restock supplies — spend it however you like to grow your business.
- A good option if you have bad credit. As debt factoring isn’t your typical business loan product, factoring companies will typically bypass your credit check when accepting applications. Instead, they’re more interested in your customers’ creditworthiness as they’re the ones who pay the invoice.
The disadvantages of debt factoring
It’s good to weigh the pros and cons before making any business finance decisions. Here are some risks to be aware of.
- Reduces profits. If your margins are thin, debt factoring might not be an affordable finance option. Factoring fees can be 1-5%, plus these companies charge a management or service charge, so consider this when weighing up whether it's worth the cost.
- It can damage existing customer relationships. You lose personal communication with your customers by outsourcing your credit control to a third party. If they're large customers, then it might not matter too much. If you're dealing with smaller firms, it might skew their perception of you.
- Customers are aware. As the invoice factoring company chase the customer for payment, you can’t keep it a secret that you’re working with a factoring company. If you want to remain in control of chasing customer payments, you can apply for invoice discounting instead.
- You might end up paying if the customer can’t. Depending on the type of debt factoring you apply for, such as recourse factoring, you could be lumbered with paying the debt factoring company yourself if the customer refuses to pay. That’s why it’s a good idea only to sell the invoices of trustworthy customers.
To sum up
While debt factoring improves cash flow, it also comes with costs and risks; always weigh the benefits with the risks before deciding that debt factoring is for you. Plenty of business finance options are available for small and medium businesses, like short-term or unsecured loans, so if debt factoring isn’t a good fit, there are other ways to access working capital.
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