What Is Debt Factoring?

by Luke Arthur; Updated September 26, 2017

When you own a company that sells products or services on credit, trying to collect the balances owed to you can be difficult. Instead of trying to collect these balances, you could use debt factoring to get access to the money you need quicker. Debt factoring is a way to sell your debt to a third-party for a fixed sum of money.

How it Works

The basic idea behind debt factoring is that you sell a portion of the debt that you are owed to a third-party. This process is also sometimes referred to as invoice factoring or accounts receivable financing. When you set up a sales contract with a customer, the customer owes you a certain amount of money. Instead of having to wait on the customer to pay his bill, you can sell this account to a factoring company and get part of the money right away.

Discounting

To make this strategy work, the factoring company has to discount the invoice that it purchases. The factoring company pays less than what you are actually owed by the customer. Then the factoring company has the responsibility of collecting this amount from the customer. When the factoring company collects the full amount of the bill from the customer, it keeps the extra money as a form of interest on the total amount of money that you borrowed.

Benefits

One of the benefits of debt factoring is that you do not have to deal with the collections process. Instead, you get money immediately from the factoring company. Then the factoring company has to worry about collecting the debt. You do not have to deal with delinquent accounts or those that do not pay their bills. Another benefit of this process is that it can increase your company's cash flow and make it easier to meet short-term obligations.

Drawbacks

One of the drawbacks of using debt factoring is that you have to pay relatively high interest rates on the money that you borrow. Even though you do not necessarily pay the interest on the front end, you have to sell the invoice at a discount. This cuts into your profit margins on each sale. Another problem with debt factoring is that it creates a situation where you have to rely on it to pay your bills; it can be hard to get away from it once you start it.

About the Author

Luke Arthur has been writing professionally since 2004 on a number of different subjects. In addition to writing informative articles, he published a book, "Modern Day Parables," in 2008. Arthur holds a Bachelor of Science in business from Missouri State University.