Debt factoring is another term for invoice or accounts receivable (A/R) factoring. It is when a business in need of quick cash sells its unpaid receivables to a factoring company at a discount. In debt factoring, the factor typically assumes the responsibility for collecting on the unpaid invoice.
How Debt Factoring Works
A business sells its unpaid invoices to a factor, which then sends money to the business in two installments. The factor pays the first installment, or the advance, which is typically 75% to 90% of the invoice’s total value, after receipt of the invoice. The factor pays the second installment, or the rebate, once it successfully collects on the invoice.
Who Debt Factoring Is Right For
Debt factoring is an easy and fast way for a business to acquire immediate funding. Indeed, while approval for a bank loan can take weeks, the process in debt factoring can be as fast as a single day.
Since debt factoring is debt-free—a business doesn’t borrow money but rather sells an asset—it is, therefore, more flexible than other traditional lines of credit. This means that small companies or start-ups, which might have difficulty qualifying for traditional bank lines of credit, can benefit from debt factoring.
Determining Debt Factoring Costs
There are many elements that a factoring company looks into that ultimately determine the overall cost of a factoring agreement. Perhaps the most important one is the debtor’s creditworthiness. Naturally, creditworthy debtors will mean less risk for a factor. Another is the number of invoices a business wants to factor, followed by the industry a business is in.
Pros and Cons of Debt Factoring
The most obvious advantage of debt factoring is that it is a quick way for businesses to acquire cash. Indeed, in debt factoring, a business will receive cash even before the customer pays.
Another advantage is that with factoring agreements, a business can save time and resources by outsourcing the tedious task of debt collection to a factoring company.
One disadvantage of debt factoring is the cost. Of course, one is necessarily spending money selling receivables at a discount. Also, debt factoring is typically more expensive than traditional lines of credit.
Debt factoring is a fast and easy way for businesses to get immediate funding to keep their short-term budgets under control. Small companies or start-ups that might find it difficult to qualify for traditional lines of credit might find debt factoring the best solution for their short-term cash flow problems.