What is Debt Factoring and How Does It Work?

MSMEs or small businesses in India have numerous options to choose from when it comes to financing business.

Young companies have a wide range of options for stabilizing their working capital through various means of financing availability.

One such option to turn to for MSMEs is debt factoring.

What is Debt Factoring?

New entrepreneurs have various options for maintaining their working capital, ensuring business continuity, and, above all else, ensuring that their balance sheets and cash flows are always positive.

Debt factoring or invoice factoring is one such financial tool that assists young entrepreneurs and businesses to deal with financial issues.

Debt factoring is a financial process that allows organizations to rapidly release funds held in outstanding invoices without waiting for the customary payment terms by selling their accounts receivable to a third party at a discount.

In effect, a debt factoring company purchases the invoice from the business, pays them a portion of the entire amount charged to the client on the invoice, and accepts complete responsibility for obtaining payment from the customer.

Why do Businesses Need Debt Factoring?

It eases the load of chasing and reminding customers or clients to make their due payments on time from the company.

Debt factoring involves an approval procedure, after which companies proceed to the debt factoring agreement and payment if everything is verified. The debt factoring company provides 80–90% of the invoice value to the business.

The debt factoring company will pay the remaining 10-20% minus any fee once it receives the whole amount from the customer. The cash acquired can be utilized to pay for necessary business expenses, such as purchasing additional stock, paying electricity bills, paying employees their salaries, and buying other equipment.

How does Debt Factoring Work?

Debt factoring involves the following parties: a business (seller), a client or customer (buyer), and a debt factoring company (third party). A business or a seller sells its products or services to its customers or clients on credit, meaning customers are not obliged to make the entire purchase payment immediately and can pay later on a mutually agreed due date.

A client or a customer is an entity or an individual that purchased the goods or hired the service; they are also the ones who must make the payment.

The debt factoring company is a third party that collects payment from the customer and purchases the original invoice from the business.

Generally, the debt factoring company pays the business a significant portion of the initial amount the client owes after verifying and purchasing the invoice. Debt factoring immediately pays up to __80% of the invoice value __to the company.

Later, when debt factoring companies collect the payment from the customer, it pays businesses the remaining 20% minus any factoring commission or fee. The debt factoring company is responsible for following up with the debtors to collect payment on the bills. This type of financial assistance helps companies not to wait for two to three months for a smooth flow of working capital.

Debt Factoring Example

To better absorb the concept of debt factoring, let us use the following example-

A company sells its products to its customers on credit i.e customers can purchase products first and pay at a later time. The payment date will be mutually decided and agreed upon by both parties. For example, a sale on credit allows the customers to make payments within the next 30 to 60 days.

Meanwhile, the company that made a sale on credit faces a financial crunch to run its daily business operations, like paying the electricity bills or ordering more necessary equipment.

To get access to quick cash, the company will reach out to a third party, a debt factoring company, and sell its unpaid invoices to them at a discount. The business gets paid around 80% of the outstanding invoice value immediately, helping it overcome the lack of working capital. Companies will get the remaining 20% of the payment minus any factoring fee once the debtor or the customer makes the complete payment to the debt factoring company.

Who Can Use Debt Factoring

Small and medium sized enterprises employ debt factoring as a short-term cash flow management strategy to increase their working capital cycle. Debt factoring is unquestionably a wise decision if the business wants to boost expansion and get around short-term working cash constraints.

But before turning to a debt factoring company for quick cash, it's important for businesses to understand all that a debt factoring service has to offer.

What is the Typical Charge for Debt Factoring?

The value of debt factoring fluctuates by various elements, such as the amount of the bills, the credit standing of the company's clients, the sector the business is in, and the company's overall health. Two main fees are associated with debt factoring: the advance, which is a percentage of the cash the company gets in advance, and the rate which is the cost of financing. Rates range between 1.5% and 4% every 30 days, with advances averaging 75-85%

Debt Factoring Advantages and Disadvantages

Debt factoring certainly eases the financial crunch faced by businesses, but it comes with its own set of advantages and disadvantages. Below are the few advantages and disadvantages of associating with debt factoring companies for a constant cash flow.

Advantages of Debt Factoring

1.Easy access to working capital One of the most significant advantages of debt factoring is quick and easy access to working capital or cash. Small and medium-sized companies usually sell their goods and services on credit, which allows their customers to pay the entire amount later.

Owing to this, businesses tend to fall short of their working capital, which can often hinder everyday business operations. Companies can avoid a lack of working capital due to sales made on credit by reaching out to debt factoring companies to access easy cash by selling their unpaid invoices. It improves their cash flow and enables businesses to use or reinvest that money as they see fit.

2.Saves Time Reaching out to debt factoring companies can save businesses a lot of time. Since businesses make sales on credit, customers sometimes do not pay back the entire amount on mutual agreement of payment period.

In this case, companies might have to keep reminding and chasing them to make the complete payment by the due date. Businesses involving a third party, like a debt factoring company, take full responsibility for getting the entire amount from the customer on the due date and can charge a penalty for late payments.

This way, businesses can sell their products or services and access quick cash by selling their unpaid invoices to debt factoring companies and focusing on their core business.

3.Accelerates Growth Debt factoring ultimately results in accelerated growth, which can cause businesses to boost their revenues, allowing companies to reinvest the factor's money wisely.

A thriving firm is expanding. Thus, it stands to reason that those who use debt factoring will likely have adequate funding for their operations and trade. Debt factoring may become less and less necessary when the company accumulates its funds and takes on more business once growth has taken root.

It can help resolve business financial challenges and boost cash flow and expansion. It enables all types of companies to quickly access funds for their ongoing operations and reinvestment reasons for a minimal fee.

Disadvantages of Debt Factoring

1.Decreases Total Profit The debt factoring company's fee is always a proportion of the total invoice amount. Businesses can get the assistance they need during their financial crunch. However, it will make less profit considering the fee charged by the debt factoring company.

Usually, debt factoring provides 75-80% of cash immediately; the precise sum depends, among other things, on the customer's creditworthiness and the duration of the business relationship.

2.Causes Businesses to Face Temporary Debt While debt factoring gives businesses access to working cash immediately, it also puts them in debt immediately.

The entire amount is paid off to the company when the consumer pays the invoice; if there are issues in the meantime, it may result in bad debt.

Since the company is in debt to the factor, problems could arise if a client disputes the invoice or pays it late.

Before lending the money, it should be clear who will ultimately be responsible for paying any missed invoices. If you have agreed to factoring with recourse, then you will be responsible to buy back invoices from the factoring company.

3.Customer Service Can be Impacted Business entrepreneurs realize the importance of providing commendable customer service and understand the critical significance of maintaining a stellar reputation with their clients or customers.

One disadvantage of factoring is that businesses give up control over how customers pay the invoices, and they might not appreciate how the debt factoring company handles payment collection.

Is Debt Factoring Short or Long term? Small and medium-sized businesses use debt factoring as a short-term cash flow replenishment measure. MSMEs look to increase their working capital while they face a financial crunch due to sales made on credit.

Debt Factoring vs. Invoice Discounting

Debt factoring and invoice discounting have various similarities and differences between them. Let's dive deep into their similarities and what sets them apart in real-world business scenarios.

Debt factoring: Businesses usually sell their unpaid invoices to a third party, a debt factoring company, at a discount for immediate cash.

The debt factoring pays the company up to 90% of cash upfront and pays the remaining amount once the factoring company receives the entire amount from the customer.

Here, the debt factoring company takes complete responsibility for getting the due amount from the customers. This is similar to non-recourse factoring where the factor is responsible for the loss of customer non-payment and takes the onus of protecting the borrower from bad debts.

Invoice discounting: An invoice discounting company lends a portion of the money shown on a business's accounts receivable ledger.

Once the company has raised the outstanding invoices, the discounting provider offers a loan equal to a percentage, often between 80 and 90 percent of the total invoice amounts.

The firm is responsible for getting the money back from the customer when an invoice discounting process is applied.

The company that used the discounting invoice service can repay the loan to the invoice discounting company after this recovery is realized.

Additionally, the business will be required to pay an upfront fee, often between three and five percent of the invoice's total value, to cover interest, costs, and risks incurred by the discounting provider.

As one can see, the fundamental operation of each of these financing options is very similar.

Few aspects that sets these two apart are:

Value Added Services Debt factoring companies provide various value-added services to businesses, including debt collection and complete sales ledgers. However, invoice discounting does not accompany these value-added services.

Percentage of Invoice Amount Debt factoring provides firms with significant liquidity — up to 85 to 90% — to enhance their cash flows. However, invoice discounting businesses comparatively provide a lesser part of the total value of the outstanding invoices.

Confidentiality In the debt factoring process, businesses' customers know the third-party involvement and deal with them to pay the final amount. However, invoice discounting is a private process; a business's customers won't be aware that they've gotten an invoice discounting loan from a third party.

Debt Collection When a business approaches a debt factoring company for monetary assistance by selling their outstanding invoices, the debt factoring company takes the responsibility to collect the final amount from the customer.

This aspect helps businesses save a lot of time by not worrying about the payment from the customer. However, invoice discounting works differently. During an invoice discounting process, the company is responsible for collecting the final price from the customer to pay it back to the invoice discounting company.

Is Debt Factoring Right for Your Business?

Small and medium-sized businesses use debt factoring to boost their working capital cycle as a short-term cash flow measure.

If your business is looking to accelerate growth and escape temporary working capital blockages, debt factoring will undoubtedly be a good choice.

However, debt factoring comes with its share of pros and cons, and it is necessary to know everything a debt factoring company has to offer before approaching one for quick cash.