Debt factoring is a financing product that small businesses take advantage of to maintain working capital and fund day-to-day operations. Also known as accounts receivables factoring or invoice factoring, debt factoring is a process of selling accounts receivables or payments owed to your small business to receive immediate cash.
In this article we are going to go over the basics of debt factoring, discuss the advantages and disadvantages of debt factoring, and discuss how debt factoring can help your small business.
Debt factoring, accounts receivables factoring, or invoice factoring is a financing product where a small business sells their invoices to the lender in exchange for immediate cash. Usually, payments are paid in terms – often 30 days. That means that your small business made a sale to a client, but they have 30 days, or the length of the term, to pay the amount owed. By selling the invoice to a factoring company, the client has until the end of the initial term to make the payment to the factor instead.
Sometimes a small business owner needs immediate cash and cannot wait for their clients to pay the money owed on their invoices. In that case, small business owners can take advantage of debt factoring by taking on a little bit of debt via interest in exchange for immediate cash. By the end of the factoring term, the small business owner will pay the lender interest and a lender fee, and their client will pay the invoice amount to the lender.
Accounts receivables factoring is perfect for small business owners who work with contracts and need to leverage secured money from invoices. By using debt factoring, you can utilize that income much sooner than waiting for your clients to make their payments.
Another advantage of debt factoring is the process itself – the lender manages your invoices. This saves you the hassle of collecting customer payments and following through with contracts or hiring somebody else to do it. Debt factoring helps you improve your cash flow for your small business.
Every lending product comes with some financial risk, and debt factoring is not without its disadvantages. First, interest rates for debt factoring are often higher than for traditional bank financing products. Another disadvantage of debt factoring is the risk of factors and the risk of customers influencing either or both relationships.
There is financial risk due to the relationship with the client – if they don’t make the payments, your interest rates will go up, impacting your credit and your relationship with your factor company will be jeopardized. A factor company could also look into your client relationships, or might contact your clients to let them know they will be collecting payment instead. This might influence your relationship with your clients, who might question your financial stability or business strategy.
On the other hand, your clients themselves might also be a risk to the relationship with the factor company. Your clients could influence your relationship with the factor company because if your factor company thinks your clients are inherently risky, they might not accept terms to debt factoring through that client at all. This might also influence the trust your factor company has in your business decisions.
Generally, you should expect factor companies to look into your credit history, as well as the credit history of your customers. If your customers are frequently making late payments, or their credit reports are weak, your relationship with your factor company might be at risk. The length of contracts with the customers, and the length of time you both have been in business will also impact lender decisions.
Debt factoring helps small business owners bridge gaps or make emergency purchases to maintain operations. By utilizing debt factoring, your small business can take advantage of secured funds and increase working cash flow much quicker than waiting for clients to follow through with contract payments.
Debt factoring is just one financing option that small business owners can utilize to manage their financing plans. Talk with your financial professional to find out if invoice factoring is right for your small business.
Jake is the Chief Marketing & Strategy Officer at SMB Compass. Jake is also the President of Reach Digital, an internet marketing company.