Debt Factoring: What It Is, Advantages and Disadvantages
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What is debt factoring?
Debt factoring is where a business sells its invoices at a discount to a third party, typically a factoring company, in exchange for an advance of cash. This type of financing is also called invoice factoring or accounts receivable factoring.
Debt factoring allows you to access capital that’s tied up in unpaid invoices without having to wait for your customers to settle their bills.
Debt factoring should not be confused with debt financing which doesn’t involve the sale of an asset but instead secures funding through a lender who requires repayment at a later date.
How much do you need?
We’ll start with a brief questionnaire to better understand the unique needs of your business.
Once we uncover your personalized matches, our team will consult you on the process moving forward.
How does debt factoring work?
With debt factoring, a factoring company buys your outstanding invoices and advances you a percentage of the total amount. For example, a company might advance 90% of a $100,000 invoice, so you receive $90,000 and the remaining 10% is kept in a reserve account. The company then assumes responsibility for collecting payment from your customers.
After your customers pay their invoices, you receive the difference between the funds you were given upfront and what was ultimately collected — minus the factoring company’s fees. Say, for example, the company charges a factoring fee of 1% of the total invoice amount for each week it takes your customer to pay. Your customer pays after four weeks, so you’ll pay $4,000 in fees and receive an additional $6,000 from the factoring company — $10,000 in the reserve account less $4,000 in fees equals $6,000.
In total, you received 96% of the invoice value, $96,000 of the original $100,000, and the factoring company received $4,000 in fees. This calculates to an approximate annual percentage rate, or APR, of 57.23%.
Advantages of debt factoring
Improves cash flow
Debt factoring allows you to get the cash from your invoices without having to wait for your customers to pay, thereby improving your cash flow.
This type of financing gives you immediate access to the capital you need to run and reinvest in your business. You can use this cash to pay everyday expenses, make payroll or take advantage of a new business opportunity, without taking on a debt payment.
Fast access to capital
Factoring companies can provide you with the capital from your unpaid invoices quickly, sometimes within 24 hours of your application.
With the invoice factoring company AltLINE, for example, you can submit a quote request and talk to a representative within 24 hours. After you’ve completed the application process and received approval, you’ll typically have access to your funds within one to two business days.
Although your funding time will vary based on the company you work with and its underwriting process, debt factoring can provide funds much faster than some types of business loans, like those from banks or SBA loans backed by the U.S. Small Business Administration.
Flexible qualification requirements
Debt factoring can be easier to qualify for compared with other business financing options. Instead of solely relying on traditional business loan requirements, factoring companies tend to focus more heavily on the creditworthiness and reputation of your customers — meaning startups and businesses with bad credit may be able to qualify.
Plus, because the invoices secure your financing, factoring companies don’t usually require additional physical collateral. This allows you to protect your assets, and it’s particularly useful for newer companies that may not have major assets to offer.
Saves time and resources
With debt factoring, you don’t have to worry about collecting payments from your customers, saving you time and resources that can be invested in other parts of your business. This can be particularly helpful for smaller companies that don’t have the budget to devote to following up on invoices.
Payment collection is also one of the distinctive differences between debt factoring and invoice financing. With invoice financing, the lender doesn’t buy your outstanding invoices, so you remain responsible for collecting customer payments.
Disadvantages of debt factoring
Reduces profit and can be expensive
Debt factoring reduces your profit because you receive less than the total amount the invoice was worth.
Although factoring companies can charge fees in different ways, you’ll typically pay a factor fee of 1% to 5% of the total invoice amount per a set period of time until your customer pays. Some companies also charge extra fees, such as account maintenance, ACH fees or cancellation fees.
When you calculate debt factoring fees into an APR, you’ll often find that they’re expensive, especially compared with SBA or bank loans.
Not suitable for all businesses
Debt factoring is a good option for business-to-business companies because their sales involve invoices. Other businesses, however, won’t be eligible for this type of financing.
If your business sells products or services directly to consumers, you’ll have to consider alternative loan options for fast cash.
Loss of control over payment collection
Some business owners may feel uneasy about relinquishing control of their collections process to a third party. You might be concerned that you’re interrupting your relationship with customers, especially if the factoring company’s method of collecting payments is unclear.
You can research a factoring company to ensure it’s reputable and its collection methods are ethical. If you’re still hesitant to lose control of payment collection, you might consider invoice financing instead.
Could be responsible for debt if customers don’t pay
Depending on the terms of your factoring agreement, you may be held responsible for the debt if your customers don’t pay. With recourse factoring, you’re required to buy back invoices from the factoring company and attempt to collect payments from customers yourself.
In other words, you’re repaying the company the funds it’s owed, and you must accept the loss if you can’t collect payment. Recourse factoring is the most common type of factoring, although in some cases, non-recourse factoring — where the factoring company is responsible for nonpayment — may be an option. Non-recourse factoring, however, often involves higher factor fees and can be more difficult to qualify for.
Is debt factoring right for my business?
Debt factoring can be a good short-term financing option for B2B businesses that have cash tied up in unpaid invoices. This type of financing can help you manage your cash flow, cover day-to-day expenses or promote business growth.
Startups and businesses with bad credit might consider debt factoring if they can’t qualify for other options as long as they have unpaid invoices to work with.
Debt factoring can be expensive, however, so if you can afford to wait for your customers to pay, you may want to consider other funding options. Along these lines, if you can qualify for a low-interest business loan, it will likely be a more affordable option for your business in the long run.
Alternatives to debt factoring
If your business doesn’t operate under a B2B model or you prefer to keep control of your accounts receivable, there are other options to raise money for your business.
Small business loans
Small-business loans and other debt financing options allow you to borrow money from a lender and repay the debt over time. Like debt factoring, you’ll typically receive a lump sum of money to use for your business, but you’ll also have a debt that will require regular payment monthly or weekly.
Equity financing
If your goal is to avoid adding another monthly payment to your business budget, you may want to consider equity financing where you raise money by selling shares in your business. Although there’s no loan to repay with equity financing, you must be willing to give up a portion of ownership in your company.
Business grants
If you’d prefer to secure funding for your business without taking on debt or giving up any ownership, you may want to research the numerous small-business grants offered by government agencies and non-profit organizations.
Some programs are designed for specific groups such as small-business grants for veterans and business grants for Black women or are specific to a particular state. While this free money is attractive, the competition for these grants is typically quite fierce.
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