Many small businesses find it tough to access credit when they need a quick infusion of cash. Overdrafts can be expensive and bank loans come with all sorts of onerous covenants and qualification criteria. Another option is debt factoring. With this type of financing, you sell your accounts receivable at a discount to get fast access to cash.
Debt factoring is the process of selling your unpaid customer invoices with the aim of getting the money in much more quickly than if you waited for the customer to pay.
Debt factoring is the process of selling your unpaid customer invoices, known as accounts receivable, to a debt factoring provider or "factor." The factor now owns the debt and chases payment from the customer. Typically, you receive around 80 percent of the invoice value almost as soon as you submit the invoices for factoring. Once the customer pays up, the debt factoring company will give you the remaining 20 percent of the invoice less their provider's fee.
Most commercial invoices are based on net-30, 60 or even 90-day terms, which means it will be several weeks before you're paid for the work you have completed. Even then, not all customers will pay their bills on time and some will not pay at all. Debt factoring assures payment of the invoice much sooner, which reduces the cash cycle for the business. This is good news if you urgently need to pay bills, buy supplies or repair an important piece of equipment.
Businesses use debt factoring as an alternative to tapping out their overdraft when they need to reduce temporary cash flow problems. It also protects against bad debts since the debt factoring company is taking on the task of collections and the risk that the customer will not pay. For small businesses, in particular, the fees you pay to the factor may be lower than the cost you would incur if you brought your invoice management in-house. You no longer need a staff member who is dedicated to managing your customer payments and debt collections, which can reduce your overhead.
There are two types of debt factoring known as recourse and non-recourse. With recourse factoring, you remain liable for payment of the invoice. If the customer does not pay after a specified period, you must pay back the advance and the factoring company's fee. With non-recourse factoring, the risk of non-payment passes to the factor. If the customer does not pay, you keep the cash advance and the factor takes the loss. Unsurprisingly, you can expect to pay a higher fee for non-recourse factoring. It also takes longer to arrange as the factor will scrutinize your customers' credit ratings to make sure that the invoices you're factoring stand a good chance of being paid on time.
Factors typically charge a fee known as a discount rate, in the range of 0.5 percent to 5 percent of the invoice value per month. The discount rate is charged weekly or monthly, so the longer it takes your customer to pay, the higher the total factoring cost. Some businesses find it helpful to translate the factor's discount rate to an Annual Percentage Rate, which you can easily do using an online APR calculator. Across the board, factoring rates are considerably higher than the rate you'd get for a conventional loan – 28-to-60 percent APR for debt financing versus 7-percent APR for long-term financing. The APR may not tell the whole story, however. Since you're borrowing money for such a short period, the actual cost of borrowing may be relatively small.
For some small businesses, debt factoring is the business equivalent of payday loans. It can be hard to break the cycle of relying on factoring for working capital once you've gone down that road. There's also the risk of upsetting customers if the factor is unprofessional or heavy-handed when collecting the debt, and you can end up out of pocket if a recourse invoice lands back on your books. You can mitigate some of these risks by choosing a reputable factor and relying on this type of financing only sparingly.