Debt Factoring: How It Helps Businesses | SMB Compass
Ezra Cabrera | May 22, 2020
Many are wondering, how does debt factoring improve cash flow? Debt factoring, also known as accounts receivable factoring or invoice factoring, is a great financing option for business owners looking for fast cash. This type of funding allows you to sell your pending invoices to a lending company at a discount in exchange for upfront capital.
Most lenders can finance up to 80% to 90% of the total invoice value. The remaining percentage, minus a transaction fee, will be given once your customers pay their invoices. Some lenders may even cover 100%, but they may charge higher interest rates to offset the risk.
Sometimes, business owners don’t have the luxury to wait for 30, 60, or 90 days to receive payment. With debt factoring, you can immediately receive the money within 24 to 48 hours. You can use the funds for almost any type of business expense, from making payroll to purchasing inventory. Below are the debt factoring advantages and disadvantages:
Advantages of Debt Factoring
Before applying, it’s important to weigh your options. To help you out, here are some of its advantages.
1. Outsource Tracking and Collecting Payments
Keeping track of pending invoices and contacting late-paying customers are time-consuming tasks nobody wants to do. With debt factoring, the lender is in charge of tracking and collecting payments. When this is the case, you inherit more time to deal with pressing tasks, while your lender makes sure that your customers pay on time.
2. Professional Payment Collection Process
It’s a common misconception that factoring companies “chase” your customers for payments. Keep in mind that lenders want your customers to pay their dues as much as you do. So, they assign a well-trained collections team to track payments.
As long as you’re working with a reputable company, you don’t have to worry about collecting payments. This saves you time and effort, not to mention, the expense of hiring a collections agency to do the job for you.
3. Better Chance of Approval
Unlike bank loans, credit rating, collateral, and loan history aren’t key factors in qualifying for debt factoring. Factoring companies are typically more concerned with the payment history of your customers since they’re the ones paying for the invoices. This gives lenders a good idea of the level of risk they’re going to take. If your credit score is low or if you don’t have enough collateral, you may be eligible for this type of financing option.
4. Addressing Short-Term Cash Flow Issues
Late-paying customers can cause cash flow issues in the long run. Business owners need a quick and affordable financing solution to get their business through tough times. With accounts receivable factoring, you’ll receive the money owed to you without waiting for months. This can come in handy if you have short-term business expenses, like paying your suppliers or purchasing raw materials for a project.
5. Instant Cash
If you apply for traditional business loans from banks, it typically takes months to get approved. If you do qualify, it will take another week or two to receive the funds from the bank. You can’t afford to wait for months for a bank loan if you need instant cash. Debt factoring gives you quick access to cash within 24 to 48 hours. This keeps your business running smoothly even if you’re faced with short-term financing needs.
6. Take on Bigger Projects
Most of the time, additional working capital is all you need in order for you to take on new and larger projects. Small businesses often lack the financial resources to fund this, especially if their current invoices are still unpaid. You don’t have to pass up on growth opportunities when you don’t have quick access to cash when invoice factoring is available.
Disadvantages of Debt Factoring
With the advantages come the disadvantages of invoice factoring. Here are five:
1. Customers with Poor Credit Ratings May Not Qualify
As mentioned, lenders are more concerned with your customers’ creditworthiness rather than yours. This means they will only buy invoices from creditworthy customers. If most of your clients have bad debts or if they regularly pay late, the lending company may not accept your application.
2. Slow-Paying Customers = Higher Fees
If you have slow-paying customers yet still qualify for debt factoring, keep in mind that you are typically charged a factoring fee for each day that your invoices remain unpaid. In other words, the longer your customer delays payment, the higher the fees. If you know that your customers are slow-paying, it might be better if you find a more affordable loan option.
3. Higher Interest Rates than Banks
The annual interest rates for accounts receivable factoring is usually higher than traditional lenders, such as banks. However, since small businesses find it harder to qualify for bank loans, invoice factoring is many times a more viable option.
4. Lack of Control Over Payment Collections
Business owners know the importance of maintaining positive customer relationships. One of the cons of invoice factoring is that you may need to relinquish control over your payment collection process. Additionally, your customers may not like the way lending companies follow up or pursue payments.
If your customers default on invoice payments, you may be held responsible. Lending companies are not a collections agency, so it’s likely they won’t go out of their way to track down late-paying customers or customers who default on their invoices. Depending on the factoring agreement, you may end up paying for unpaid invoices or trade other invoices of similar value to cover the cost.
How Debt Factoring Can Help Your Small Business
So, how does debt factoring improve cash flow? By allowing your company to access revenue owed to it much more quickly. It implies you’ll never have to wait for your money for the entire duration of your invoice.
With debt factoring, business owners can bridge cash flow gaps, pay for unforeseen expenses, and maintain healthy cash flow. Your business can increase working capital in an instant rather than waiting for clients to follow through with invoice payments as long as the company is knowledgeable regarding the debt factoring advantages and disadvantages.