Debt factoring is a business finance solution that enables businesses to use their accounts receivable to secure an instant cash flow boost. Also known as invoice factoring, it’s a way to turn outstanding invoices into immediate funding.
In simple terms, the business “sells” its unpaid invoices to a factoring company and receives up to 95% of the invoice value upfront, with the remaining balance less fees released once the invoice has been paid.
Due to its flexibility and fast approval process, debt factoring is becoming an increasingly popular way for businesses to generate working capital and mitigate cash flow shortages.
How Does Debt Factoring Work?
In contrast to a traditional business loan or overdraft, debt factoring enables you to use your accounts receivable as collateral to secure immediate funding.
When you submit an invoice to the factoring company, you receive up to 95% of the invoice value upfront. You can receive the initial advance within 24 hours of raising the invoice. The remaining balance is released when the invoice is paid by your customer, minus the factoring fee.
The factoring fee is typically charged as a percentage of the total invoice value and will depend on your business, your customers, and the services you require.
Debt factoring can be beneficial for any business that offers extended payment terms to its customers. If you provide your clients 30+ days net terms, you can use debt factoring to release the capital tied up in unpaid invoices for a quick cash injection.
Debt Factoring Example
To show you how debt factoring works in practice, let’s take a look at an example.
Let’s say you have completed an order and raised an invoice for $40,000. If you offer extended payment terms, you may need to wait 30+ days for your customer to pay the invoice.
Using a debt factoring facility, you submit the invoice and receive 90% of your invoice value upfront. This initial advance of $36,000 is released within 24 hours of you submitting the invoice. You can use this cash injection to pay suppliers, cover overheads, and start work on new orders.
Your customer pays the invoice, and the finance company releases the remaining balance of the invoice less fees. The finance company charges a 2% factoring fee for the facility. Of the remaining 10% of the invoice ($4,000), you receive $3,200.
In total, you receive $39,200 of the $40,000 invoice. Your profits are slightly reduced, but you have sufficient working capital to pay suppliers and take on new orders.
Invoice finance can be an effective funding tool to accelerate business growth.
Debt Factoring vs. Invoice Discounting
Debt factoring and Invoiceidiscounting provide a similar business funding solution. They both enable you to access an upfront payment for your outstanding invoices.
However, there are some significant differences. In simple terms, debt factoring involves selling your unpaid invoices to the finance company. Invoice discounting is more like a loan secured using your outstanding invoices as collateral. You use your accounts receivable to access a line of credit and repay the amount owed plus any fees once your customer has paid the invoice.
The most significant difference between invoice factoring and discounting is the collection of the invoice.
With a factoring facility, the finance company is responsible for the collection of the invoice payment. Once you have raised and submitted the invoice to the factoring company, you don’t need to worry about chasing payments and managing accounts. This makes debt factoring a more suitable option for smaller businesses that don’t have dedicated accounts and collections departments.
With invoice discounting, you retain the responsibility for collections. When you raise an invoice, you are responsible for collecting payment from your customer. Invoice discounting is typically used by larger companies that have an internal collections department.
Types of Debt Factoring
You should also be aware of the different types of debt factoring before you enter into an agreement with a finance company.
Debt factoring works as described above, but there are different arrangements that can impact your liability for the factored invoices.
Recourse factoring is a debt factoring agreement where you remain liable for the value of the invoice should your customer fail to pay the debt in full.
When you enter into an agreement, the finance company will usually conduct a financial check of your customer to determine their ability to pay before agreeing to factor an invoice. This can help you to avoid becoming overextended with a customer that is operating beyond their means and protect you from bad debt.
However, if your customer fails to pay, you will be responsible for the amount owed. Recourse factoring reduces the amount of risk involved for the finance company, and you’ll typically find recourse factoring fees much lower than non-recourse factoring arrangements.
Non-recourse factoring places all of the risk onto the finance company. If your customer doesn’t pay the invoice and the debt is unable to be collected, you retain no responsibility for the sum owed.
Because this type of factoring is much riskier for the finance company, you can expect to pay a much larger factoring fee for the arrangement.
Advantages of Debt Factoring
Debt factoring offers a number of advantages, particularly for growing businesses and startups that struggle to meet the strict lending criteria for traditional bank loans and overdrafts.
Shorter Cash Cycles
Cash cycles are a significant factor in the ability of a business to grow. When you raise an invoice, waiting for your customer to pay can hinder your ability to invest in new inventory, negotiate discounts with suppliers, and take on new contracts with larger customers.
Debt factoring speeds up the cash cycle, so you can access the capital you need to fund the growth of your business.
When you enter a debt factoring agreement, the finance company will handle the account management and collections of your invoices. This means you can avoid the cost of hiring an employee to handle customer payments.
According to the HR industry publication Human Resources Director, the average cost of hiring a new employee in Australia is $18,982, without including the ongoing expense of a salary.
The application process for a traditional loan or overdraft can take from a few weeks to several months. With invoice factoring, you can be approved and receive an advance on your invoice in as little as 24 hours.
If you need capital to cover an unexpected bill or capitalise on an opportunity, debt factoring can provide a fast cash injection.
Reduce the Stress of Chasing Payments
According to a recent study by IntegraPay, 32.9% of Australian business owners spend an average of 8 hours per week chasing unpaid invoices, with 50% of businesses owed $20,000 or more at any time.
The stress of chasing payments can have a significant impact on mental well-being. With debt factoring, the finance company will perform credit checks on your customers to ensure you don’t overextend with any customers. They will also handle the collections and account management.
You can focus your time and effort on growing your business rather than worrying about late payments.
Debt factoring is much more accessible than other types of business finance. Banks and traditional lenders have strict lending criteria that makes a loan or overdraft out of reach for many businesses. This is particularly true for startups and companies with a low credit rating.
Because a debt factoring line of credit is tied to the value of your accounts receivable, as long as your business is making sales, you can always access credit when you need it.
ScotPac Debt Factoring
We offer a wide range of flexible business finance solutions to help you access the funding you need. Debt factoring can be an effective way to manage cash flow and increase working capital as your business grows.
You can use debt factoring as a primary source of funding or as a flexible line of credit that sits alongside a business loan or overdraft. If you need some more information to decide whether debt factoring is the right solution for you, give us a call and speak to a financial advisor today.