What is debt factoring?
Debt factoring (also called invoice factoring) is when a business sells its unpaid invoices to a third party (known as a factoring company) at a discounted price. The factoring company releases a significant amount (usually 75-90%) in advance. This helps the business get some cash immediately instead of waiting for customers to pay.
The factoring company then collects the payment from the customers. After the invoices are paid in full, the business gets the rest of the payment, minus debt factoring fees. In this way, the business gets quick access to cash which was tied up in unpaid invoices.
How does debt factoring work?
Debt factoring works when a factoring company purchases your business’s outstanding invoices and gives you a significant portion of the invoice value upfront. For example, if you have an invoice worth £50,000, the factoring company may advance you 80% of this amount, which is £40,000. The remaining 20%, or £10,000, is held in a reserve account.
The factoring company charges a fee for this service. Suppose they charge 2% of the total invoice amount. After your customers have cleared the invoices, you will receive the remaining amount from the reserve account, which would be £9,000 (£10,000 in reserve minus the £1,000 fee).
In total, you received £49,000 from your original £50,000 invoice. The factoring company earns £1,000 in fees.
Advantages and Disadvantages at a glance
| Advantages | Disadvantages |
|---|---|
|
Improves cash flow |
Reduces profit margin |
|
Quick Capital Access |
Can be expensive |
|
Flexible qualification |
Not suitable for all businesses |
|
No Physical Collateral Required |
Loss of control over payment collections |
|
Saves Time and Resources |
|
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Advantages of debt factoring
Improves cash flow
Debt factoring provides quick access to cash from invoices, helping businesses manage everyday expenses, payroll, and investment opportunities without accruing debt.
Quick Capital Access
Factoring companies release funds quickly, usually within 24 hours after approval as compared to other traditional business loans like bank or SBA loans.
Flexible qualification
Debt factoring is easier to qualify for than other loans, as factoring companies focus on the creditworthiness of the business’s customers, not the business itself. Debt factoring may be a suitable option for businesses with poor credit ratings.
No Physical Collateral Required
You do not need to put up any business asset as collateral for debt factoring. The invoices act as collateral, protecting other business assets.
Saves Time and Resources
In debt factoring, you outsource payment collection to the factoring company. It frees up your time and resources for other business areas.
Disadvantages of debt factoring
Reduces profit
Businesses receive less than the total invoice value, which reduces overall profit.
Can be expensive
Factoring fees (usually up to 5% of the invoice amount) may make debt factoring more expensive than other loan options.
Not suitable for all businesses
Debt factoring is best suited for businesses that sell on credit and have a turnover of £4,000+ per month.
Loss of control over payment collections
Businesses give up control over the collection process, which may affect customer relationships.
Tips For Choosing the Right Debt Factoring Company
We have compiled a list of questions that you can consider before choosing the right factoring company for your business:
How long has the company been in business?
Depending on how long the debt factoring company has been in business, its reliability increases. A long business history means they have been consistent in their services to be able to still run their business.
What are the contract details?
It is important to know the contract details in case there is any hidden fee or contract timeline. Make sure to thoroughly read it, and ask questions if anything seems unclear or confusing.
Does the debt factoring company require a minimum volume of invoices?
Some debt factoring companies won’t work with you if you have only a few invoices. They often need a minimum number of invoices, which can be a problem for small businesses if their sales go up and down a lot.
How does the debt factoring company deal with customers to handle collections?
Check reviews from other businesses that have used the debt factoring company. Find out how they handle unpaid invoices and how they talk to your clients. Their collection practices should be professional to keep your business image positive.
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FAQs
Some debt factoring providers may work with businesses having bad credit ratings but expect terms and rates to be influenced accordingly as a bad credit history indicates higher risk.
The time it takes to access cash through debt factoring varies depending on the factoring company and the agreement made between the company and the business. However, in general, businesses can expect to receive payment within 24 hours of submitting their invoices.
Debt factoring can be a good option for businesses that want access to cash tied up in unpaid invoices. It is important to note that not all businesses are eligible for debt factoring. The eligibility criteria vary depending on the factoring company and the industry. Some factoring companies may require a minimum monthly invoice volume, while others may only work with businesses that have been operating for a certain period
Yes, businesses can choose which invoices to factor. This type of factoring is called selective invoice factoring. However, the factoring company may have certain requirements for the invoices that are eligible for factoring. For example, the invoices may need to be less than 90 days old and not subject to any disputes or legal issues
