What Is Debt Factoring and When Should A Business Use It?

How debt factoring works

Debt factoring is a method of obtaining business finance by selling your customer invoices to the finance company, which processes the invoices and then lets your business draw loans against the money owed. Optionally, the finance company collects the debts from the customers and keeps the ledger records.

It can be a very convenient way to improve business cash flow, and save the overhead costs of running a sales and debtors ledger.

An alternative form of factoring finance is "invoice discounting", also referred to as debtor funding. With invoice discounting, your business usually keeps control over the debtors ledger and manages the debt collections from customers but receives 80% to 90% of the sales invoice value at a "discount" for immediate injection into your cash flow.

Invoice payments by customers are received by the finance company which sends you the balance (10% to 20% less fees) when collected.

The disclosure of the finance company's role and whether they manage the debt collection processes will depend on the arrangement offered by the individual finance company.

Advantages and disadvantages of debt factoring

The are a number of advantages to debt factoring, however there are also some drawbacks.

Advantages

factoring provides an immediate and significant boost to cash flow. A business with debtors of $300,000 could achieve a cash flow injection of $270,000 within 24 hours. Typically 80% to 90% of your good quality invoice value can be financed.
administration costs can be saved by not having to administer the sales ledger (if that is the type of arrangement)
factoring companies are very experienced, and may be more efficient debt collectors than you, and their profile may engender respect resulting in earlier payment
if your business is growing rapidly, freeing up cash from debtors can give you the cash to reinvest in the inventory or capital equipment needed to expand, and is especially useful when traditional credit lines have been used up (e.g. secured bank loans)
Negotiably with some lenders, your business can be insured against bad debts, by paying a percentage premium on the financing cost.

Disadvantages

The annualised interest cost is usually more than bank finance.
invoice queries or disputes arising can make the process administratively inconvenient
it is not suitable for businesses with cash or mainly consumer customers
it is not suitable for financing invoices to your business customers who have a poor credit record
your relationship with the customer can be damaged if there's any friction between the customer and the finance company collecting the debt
if a substantial part of your ledger is factored, it can represent a significant amount to refinance, if/when you wish to do so (all finance must be repaid, sooner or later)
factoring companies won't accept risky business practices, which may necessitate some changes to your business practices or administration
when the finance company is disclosed, some customers may only want to deal with you.
poorly performing ledgers (i.e. slow paying, or higher bad debt rates) will be more expensive to administer through a debt factoring arrangement, which may cancel out or exceed the financial benefits. In practice, bad or doubtful debts cannot be sold at their face value, or at all.
debt factoring is effectively pledging the debtors ledger as security, and will therefore not be available as security for any other business lending arrangements
If your secured lender (typically the bank) holds a general security over your business, you may not legally be able to separately raise finance using your debtors or invoices

When is debt factoring appropriate ?

Keep in mind that factoring and finance companies each have their own requirements, with varying degrees of flexibility. Typically appropriate circumstances include:

your business is well-established, trading profitably and has a sound reputation
your business is in start-up mode, without an established track record to support a traditional cash flow lending proposal, but with quality customers doing business with you
reasonable turnover level (generally over $100,000).
commercial customers
not too many small invoices
part payments are not a standard practice
payment and credit terms offered to your customers are reasonable, and within industry norms
you have a low level of invoice queries or disputes
you have a reasonable number of customers
invoice values spread over a reasonable number of customers

Invoice discounting (disclosed or undisclosed)

Under an invoice discounting arrangement, your business usually keeps the sales ledger administration in-house, and the involvement of the invoice financier may or may not be disclosed to the customer.

Fees are based on the time the customer takes to pay, the amount involved, and the crediy standing of the customer.

Many financiers will finance a single invoice, or a number of invoices, giving you the flexibility to choose the amount and timing of finance and to stop the arrangement without any further obligation.

Invoice-Finance is usually very quick to arrange and settle, without the need to supply the sort of financial information a that a bank lending (for example) would require.

In a worst case scenario (i.e. the customer doesn't pay), typically the obligation can be discharged to the financier by substituting another invoice of equal or greater value.

Invoices of $10,000 or less, up to $250,000 or more can be financed in this way.

What are the costs of debt factoring or invoice discounting finance?

Total fees typically range from 2% to 10% of the face value of the invoice depending on the type of legal arrangement, the level of service provided (such as debt collection, or bundled credit insurance) and the credit profiles of your customer and to a lesser extent, your business.

Terms are negotiable, and professional advice is recommended before signing anything.

Bear in mind that some arrangements are specified for a fixed period of time, or perhaps subject to a period of notice. If that's the case, you need to be fully aware of what's required to end the relationship should it be necessary.

Tips on Choosing a Debt Factoring Arrangement

Scrutinise the agreement documentation carefully, to ensure you understand how it works legally. The better financiers' documentation is very simple, and very clear.

what is the contract period, and period of notice?
how are the fees and interest calculated?
what happens (and what are the fees) when a client doesn't pay on time?
what happens (and what are the fees) when a client doesn't pay at all (i.e. a bad debt)?
how are queries and disputes handled?
ensure the procedures for contact with your customers reinforce your own customer service standards

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