When a business decides to sell its unpaid invoices to an external party, this is considered debt factoring. Businesses will sell their unpaid invoices and the factoring company now owns the debt and pursues payment from customers. Businesses will approach factors that deal with accounts receivable. This arrangement is meant to improve the cash flow for the business. The factoring company will then assess the risk by analysing the financial health of the business and its receivables. Once the assessment is complete, the factoring company will draw up a quote of what percentage they can factor.
Typically, when a factoring arrangement is first entered into, the factors will pay the business in advance for outstanding invoices. Debt factoring is usually a long-term agreement as the factoring company will be involved in the business’s sales process. Any new sales by the business will have to involve the customer and the factor.
The biggest advantage to debt factoring is that it unlocks funds tied in unpaid invoices. This will improve the cash flow of the business. They can instantly use this cash to expand their operations and invest more in their businesses. This provides businesses with peace of mind as they are not anxiously waiting for the next pay cycle. Businesses can access revenue owed to them through debt factoring. Another advantage to debt factoring is that it makes it much easier for businesses to expand overseas. The factoring company would likely have more experience with overseas suppliers
The business does not have to wait 60 or 90 days to be paid and this wait can put a major strain on the business. Insolvency can be described as the inability to pay one’s bills due to financial distress. Companies must liquidate after declaring insolvency. If a company does not liquidate then the owners of the company become responsible for the debt. Cash flow can cause serious problems in any business.
This speeds up the growth of the business as they have cash on hand to expand and continue with their day-to-day operations. It also improves customer management. Most factors will credit check customers so that the business trades with customers that pay on time. By employing the use of factors, businesses have more flexibility and are able to cover their financial obligations.
There are some disadvantages to debt factoring, such as higher interest rates than typical bank loans. Debt factoring is more suitable for companies with high profit margins because their interest rates are quite high. Non-recourse factors assume the risk of unpaid invoices – this is why their interest rates are so high. Factors also charge administration fees as they manage the sales ledger and credit control of the business. For smaller businesses, the lack resources this sort of financing requires more administration in regard to credit control. Most factoring companies will charge an administration fee as they normally manage the sales ledger and credit control of the business. Although this might give the business peace of mind, the cost of adopting this method might prove to be too much for smaller businesses.
Employing the use of factors could be detrimental to the relationship businesses have with their customers. Some customers may not want to be associated with the business if they are using a finance provider. Another disadvantage is that recourse factors do not assume the risk of unpaid invoices and it will be the responsibility of the business to clear those debts. The businesses creditworthiness is at stake when they employ the use of factors. According to Investopedia, creditworthiness is how a lender determines whether you will default on a payment or if you are worthy of receiving more credit.