Profit doesn’t always equal money in the bank. When you offer extended payment terms to your customers, you can often experience cash flow shortages waiting to receive payment for your outstanding sales invoices.
Debt factoring is a finance solution that helps businesses to overcome cash flow gaps by releasing the capital tied up in unpaid invoices. Instead of waiting 30+ days for a payment to arrive, you can quickly access up to 95% of the invoice value upfront, and receive the remaining balance once your customer has paid the invoice in full.
If you offer net terms to your customers, debt factoring can help you to get paid sooner.
How Does Debt Factoring Work?
Debt factoring typically works on a two-instalment payment process. When you raise an invoice, you submit the invoice to the factoring company at the same time as you send it to your customer. The factoring company will fund up to 95% of the invoice value upfront and deposit the money into your bank account within 24 hours.
Once your customer has paid the invoice, you receive the remaining balance of the invoice less factoring fees. When you factor an invoice, you also transfer the responsibility of collecting the sum owed by your customer. The factoring company will manage the collection of the invoice so you can focus on your next order without worrying about chasing up the unpaid invoice.
Advantages and Disadvantages of Debt Factoring
Debt factoring is an increasingly popular way for businesses to access fast funding. But there are some advantages and disadvantages that make this type of finance more suitable for some companies than others.
To help you determine whether debt factoring is right for your business, let’s take a look at the pros and cons.
Advantages of Debt Factoring
Immediate Cash Injection
You can access up to 95% of your invoice value immediately after billing your customer. Maintaining working capital can be a struggle for growing cash-hungry businesses. By releasing the capital tied up in outstanding invoices, you can get a quick cash injection to cover expenses, pay suppliers, or capitalize on new opportunities.
Cash flow is important for business growth, but also for personal well-being. According to a study published in Business Insider Australia, over half of small business owners have decided to not pay themselves a wage one or more times over a 12 months period due to cash flow shortages.
Offer Payment Terms to Customers
Larger customers usually provide the most revenue for small to medium-sized businesses. The bigger the customer, the bigger the sale. But these clients typically demand extended payment terms of up to 90 days that can be a significant drain on working capital.
If you are unable to offer net terms, you are unlikely to land contracts with larger customers. Debt factoring allows you to access the capital tied up in your unpaid invoices quickly. You can offer extended payment terms to larger customers, and avoid the cash flow issues associated with waiting for the payment.
Avoid Bad Debt
Offering extended payment terms to customers is unavoidable when you sell to other companies. But bad debt can cripple your business.
Debt factoring can protect your business from overextending with customers that are unable to pay. Most finance companies will provide a customer credit review service as part of the funding facility. You can grow your business knowing that your debt factoring partner will help you to avoid taking on problem customers that could leave you with bad debt.
Grows With Your Business
You can access a flexible line of credit that increases as your business grows, and you make more sales. A traditional business loan is usually limited by the value of the asset used as collateral.
A debt factoring facility is tied to the value of your outstanding invoices. The more sales you make, the more funding you can access. This can be especially useful if you are experiencing a busy period and need cash flow to sustain your business growth.
Easy to Access
Debt factoring is much more accessible than a traditional business loan or overdraft. While conventional lenders are risk-averse and apply strict lending criteria, invoice factoring providers are much more willing to fund businesses that don’t have a long trading history or perfect credit rating.
As long as you raise invoices for your goods and services and your customers are creditworthy, you will likely qualify for debt factoring.
No Need for Real Estate Collateral
You don’t need to use your home or personal assets to secure debt factoring funding. Conventional business loans usually require real estate or high-value assets as collateral. Factoring enables you to access financing without putting your personal assets at risk, with your invoices serving as the collateral for funding.
No Need To Sell Equity in Your Business
Angel investors are a potential source of funding for startups and new businesses. But this form of finance involves selling equity in your business. The investor will typically demand a share in profits and some control over your business. You will need to consult your business partner before making any significant decisions.
If you are experiencing a cash flow shortage, you will also be in a weak position when it comes to negotiating a fair price. With invoice factoring, you retain complete control of your business. You can set up a flexible funding facility, and use debt factoring when you need it.
To find out more about the different ways to fund your business, check out our blog post “7 Ways to Finance a Business in Australia”.
Disadvantages of Debt Factoring
Can Be Expensive
As with all sources of business finance, debt factoring can be expensive if managed poorly. Business funding should always be tied to your long-term goals and business plan. If factoring can help you achieve your goals and grow your business faster, the benefit outweighs the costs involved.
We are growth enablers and strive to find the most appropriate funding solution for your business needs. Our clients grow 3x faster than the average business.
Adds a Third-Party to Your Customer Relationships
When you enter into a debt factoring arrangement, your customer will be aware of your relationship with the finance company. While this doesn’t cause any problems for your customers, some business owners prefer to keep their relationship with the finance company confidential.
If you would prefer a confidential arrangement, invoice discounting may be a more suitable option.
Reduced Profit Margin
Invoice factoring enables you to turn your outstanding invoices into working capital quickly, but you will receive less than the total value of the invoice. The finance company will typically charge a factoring fee that is equal to a percentage of the invoice value. This can range from 1% to 3% depending on the terms of the funding facility.
For many businesses, the ability to speed up cash cycles and maintain consistent cash flow is more beneficial long-term than the loss of profit for the factored invoice.
High Risk if Customers Don’t Pay
There are two types of debt factoring; recourse and non-recourse.
Recourse factoring means you retain liability for the value of your factored invoices if your customer doesn’t pay. Non-recourse factoring means the opposite. The finance company takes on all liability for the debt.
For most businesses, recourse factoring will be the only type of available debt factoring, and you will be responsible if your customer fails to pay the invoice.
However, this risk can be mitigated by choosing a factoring company that offers customer credit reviews as part of the funding facility. The finance company will help you to avoid customers that are operating beyond their means and protect you from potential recourse from bad invoices.
We also offer bad debt protection services that can be added on to your invoice factoring facility.
Only Available if You Offer Net Payment Terms
This type of business funding is only available to businesses that offer net payment terms to their customers. If you don’t raise invoices or mainly process cash payments, invoice factoring will probably not be a suitable funding solution.
But you may be able to access a different type of business funding. If you purchase large quantities of goods or raw materials, Trade Finance may be a useful funding source.
Asset finance may be a good alternative to debt factoring if your company has significant assets like machinery, equipment, or inventory.
Debt Factoring with ScotPac
There are advantages and disadvantages to this type of funding, but debt factoring could be a good solution for your business if you have capital tied up in unpaid invoices. You can quickly turn your sales into cash in the bank.
We believe every business should have the opportunity to grow, and we strive to find a way to say yes and put funding in place. If you need some more information about debt factoring and how it can help your business, speak to a member of our friendly team over the phone or use the contact form below and we’ll be in touch.