Read on to learn more about debt factoring!
Published 5th March, 2023
Updated 10th May, 2023
Debt Factoring 101: FAQs
What is debt factoring?
Debt factoring is when a business sells its outstanding invoices to a third-party factoring company. Also known as invoice factoring, accounts receivable factoring, or AR factoring, this process helps to alleviate cash flow problems and avoid insolvency by giving the business access to money faster, instead of having to wait for customers to pay their invoices.
Table of contents
- How does debt factoring work?
- The advantages and disadvantages of debt factoring
- Is debt factoring right for your business?
- Debt factoring vs accounts receivable financing
- Debt factoring vs B2B Buy Now, Pay Later
- Proactive, flexible, online financing
How does debt factoring work?
Let’s say you offer your B2B customers purchases on invoice, (aka trade credit or net terms. While your B2B sales numbers look good, you’re still waiting to receive payment. Not having access to your entire working capital can prevent you from growing further and investing in your company.
With debt factoring, you can sell those outstanding invoices to a factoring company and get paid right away instead of waiting until the end of the invoice term. The factoring company takes over the responsibility of collecting payment and provides you with a percentage of the total invoice value (usually between 80%-90%).
Once your customer pays the invoice, the factoring company then returns the rest of the invoice value minus a small fee.
The cost of debt factoring can vary but it’s mainly based on two things - the processing fee and the service fee. The processing fee is usually between 1.5%-5% of the total invoice value.
But the service fee (also known as the factoring period fee) will depend on the term length of the invoice. For example, it’ll cost you more to factor an invoice with 60 days left than 30 days. Typically, the service fee increases the longer it takes for the customer to pay the invoice.
As a simple example, take a look at the breakdown below based on a processing fee of 3% and a service fee of 1.5%.
In this example, it would cost you €450 to factor an invoice worth €10,000.
However, what happens if your customer pays late? Many debt factoring companies use a tiered structure and increase the service fee for every week the invoice is overdue.
This means for every week over the due date your customer doesn’t pay, the cost of factoring increases.
In the new example below, the customer was 4 weeks late paying the invoice. The factoring company adds 1% per week the invoice is overdue, resulting in a higher cost of €850.
The advantages and disadvantages of debt factoring
Debt factoring advantages
Whether you run a startup business or a large multinational company, debt factoring can be used as a key element of your B2B strategy. Let’s take a look at some of these advantages in more detail:
Improved cash flow
The most immediate advantage of debt factoring is improved cash flow. By gaining access to the majority of your invoice value straight away, you no longer have to wait for the customer to pay. This means you can alleviate any cash flow issues you might have.
Gaining access to tied up capital can also help the growth of your company. Previously unavailable funds can now be used to support an expansion into a new market or the purchasing of business essentials.
Saves time and resources
Another advantage of debt factoring is that it can save your company time and resources. Managing invoices and ensuring your customers pay on time can be resource-intensive.
If they don’t pay, you’ll find yourself chasing payments when you could be focusing on more productive things. On the other hand, debt factoring passes responsibility over to the factoring company. Which means no more chasing payments.
A quicker way to obtain financing
In some cases, businesses will apply for a loan to mitigate the cash flow problems caused by invoice terms. But this isn’t always a viable option, especially if you have limited collateral or a short financial history.
Factoring companies pay the most attention to the credit scores of the customer however, instead of the business. This makes debt factoring a faster alternative to financing when compared to bank loans.
Bargaining power
Debt factoring enhances your bargaining power when dealing with suppliers. With a consistent and predictable cash flow from factored invoices, you can negotiate more favourable terms, such as discounts for early payments or better pricing on bulk orders.
This strengthened financial position enables you to build stronger relationships with suppliers and capitalise on mutually beneficial arrangements. By leveraging debt factoring, your business gains the upper hand in negotiations, fostering a more collaborative and advantageous dynamic with your suppliers.
Flexible qualification requirements
Debt factoring stands out as a more accessible financing alternative compared to other business funding options. Unlike the stringent criteria associated with traditional business loans, factoring companies place a greater emphasis on the creditworthiness and reliability of your customers. This approach means that even startups and businesses grappling with poor credit histories may find it easier to qualify for debt factoring.The security provided by your invoices means that additional physical collateral is usually not required, allowing you to protect your assets—especially advantageous for newer companies with limited assets.
Disadvantages of debt factoring
While debt factoring can offer some great fixes for your business, there are some drawbacks you should be aware of. Here are some of the potential disadvantages of debt factoring:
Reduces profit
Everything has a price and debt factoring is no different. While the factoring fee can vary from company to company, the cost of debt factoring can quickly mount up if the total value of your invoices is particularly high. In the example above, the cost of factoring a €10,000 invoice is €300.
If you factor multiple invoices, however, with a total value of €1,000,000, it’ll cost you €3000 (assuming a factoring fee of 3%). This can eat into your profit margin which ultimately leaves you with less earnings at the end of the quarter or year.
Short-term debt
Debt factoring gives businesses immediate working capital, but it also creates short-term debt. This debt should be repaid once the customer pays the invoice, but if there are payment issues, it can result in bad debt for you.
To avoid complications like this, it's essential to agree on who is responsible for an unpaid invoice before the factor lends the money. A basic credit check of customers can also help prevent payment problems in the future.
Lost control of sales ledger
When a debt factoring company takes over invoice payment collection, you give up some control over your sales ledger and sacrifice some confidentiality. Customers are usually credit checked, and they'll know that the service has been outsourced, which could impact customer relations.
Is debt factoring short term or long term?
Debt factoring is generally considered a short-term financial solution for businesses facing cash flow challenges. While debt factoring provides access to previously tied up working capital, it's crucial to note that it introduces a short-term debt for businesses. While the intention is for the debt to be repaid when the customer settles the invoice, any delays or payment issues could result in the accumulation of short-term debt for the business.
Businesses considering debt factoring should carefully evaluate its short-term implications, including associated costs and the potential impact on financial stability, before deciding if it aligns with their business goals.
Is debt factoring right for your business?
In broad terms, debt factoring is most appropriate for companies engaged in B2B transactions with credit terms, particularly those with an annual turnover exceeding £50,000.
Startups or businesses facing credit challenges may consider debt factoring when alternative financing avenues are limited, given that they possess outstanding invoices.
Nevertheless, it's important to note that debt factoring can result in significant expenses. Each invoiced transaction involves costs, especially if debt factoring becomes the primary method for handling invoices. If waiting for customer payments is a practical option, it is advisable to explore more cost-effective funding alternatives, such as low-interest business loans, to ensure long-term financial stability.
Deciding whether debt factoring is right for your business will depend on several elements but broadly speaking, businesses that offer trade credit can benefit from it. However, you’ll need to decide if the disadvantages of debt factoring are worth it for you. For example:
1. Is it a financially viable option for you? As we’ve discussed, debt factoring reduces profits thanks to the cost involved. If you have many outstanding invoices and choose to access tied up working capital this way, those fees can quickly add up.
2. Are you prepared to take on short-term debt? If you offset the collection process for unpaid invoices to a factoring company, you’re essentially taking on a loan. While it’s true that you’re receiving cash up front for tied up capital, you owe the factoring company a fee for their services.
3. Are you happy that your customers know? If your customers are aware that you’re using a factoring company, it could negatively impact your reputation. While invoice factoring frees up cash and allows you to be more agile, your customers may view this is a sign you need the money.
While debt factoring can be a valuable short-term solution for B2B businesses grappling with delayed payments, careful consideration of the associated costs and potential impacts on finances and reputation is crucial. Assess your financial viability, willingness to take on short-term debt, and the implications for customer relationships before deciding if debt factoring aligns with your business goals.
Debt factoring vs accounts receivable financing
Despite sometimes being used interchangeably, there are some distinctions between debt factoring and accounts receivable financing.
With debt factoring, the lender pays you a portion of the invoice upfront but now owns the invoices, bought from you at a discount. This means they are the ones responsible for collecting payment. With accounts receivable financing, you keep ownership of the invoices and use them as collateral to secure a loan or line of credit.
With accounts receivable financing, a lender also advances you a percentage of the value of your receivables - as much as 90%. Once your customer pays their invoice, you receive the remaining balance minus a lender’s fee.
Lender’s fees can vary depending on the financing company but generally they’re between 1-5%. Bear in mind though, that the amount you pay in fees is based on how long it takes your customer to pay their invoice. The longer they take, the more expensive it is for you.
While both serve the purpose of improving cash flow by accelerating receivables, debt factoring can encompass a broader scope beyond invoices, including loans and other debts owed to a business.
Understanding these differences is essential for businesses seeking the most suitable financing option based on their unique financial needs.
Read more about accounts receivable financing.
Debt factoring vs B2B Buy Now, Pay Later
The demand for flexible B2B payments has been the driving force behind advances in embedded finance and automated payment reconciliation. With that, comes the application of B2B buy now, pay later, offering a simpler way of offering your business customers net terms with some considerable benefits including:
- Increased conversions rates, B2B sales, and average order value
- Drastically reduced admin time
- Offsetted credit and fraud risk
- Improved cash flow
Stuck chasing payments? A 2022 Barclays study revealed that 58% of SMEs experienced late invoice payments from customers, so you're not alone. Download our free CFO's guide to Buy Now, Pay Later for B2B ebook to learn more about upfront payments, reduced admin, and improved operational efficiency.
When you consider that 1 in 5 corporate insolvencies are due to late payments, B2B buy now, pay later can solve many issues these businesses face. Getting paid upfront, for example, eliminates the need for debt factoring as businesses receive payment for their trade credit sales at the point of sale.
When compared to debt factoring, B2B buy now, pay later is also far more streamlined and cheaper.
Some players in this space are strictly finance providers, whereas others are full-scale B2B payment suites (like Two!) that take care of everything from credit checking and customer verification, to payment reconciliation and invoice management.
So what are some of the key differences between BNPL B2B and debt factoring?
Proactive, flexible, online financing
Traditional debt factoring can be time-consuming and reactive, making it difficult for businesses to access their working capital. Selling on net terms means waiting for payment, which can hurt growth and requires companies to take on credit and default risks.
B2B Buy Now Pay Later offers a solution by paying businesses upfront for their invoices. The seller doesn't have to collect payment because integrated financial partners handle it through the B2B BNPL platform.
With traditional debt factoring, there can also be discrepancies between the credit risk established by the seller and what invoices the lender is willing to buy. For example, a seller may offer trade credit after running credit checks, but the lender may still deem the risk too high to finance.
B2B BNPL solves this issue by making the credit decision at the checkout instead of after the sale. Additionally, dynamic credit limits based on the customer's risk profile make B2B BNPL a superior option. Merchants can access credit limits in real-time thanks to advanced credit engines built into the B2B BNPL platforms, creating a streamlined invoice financing option.
Two - The highest net term credit limits for B2B. Instantly.
Two’s payment technology enables businesses across all industries to offer purchasing on invoice, providing a frictionless checkout experience with instantly approved credit. Our revolutionary B2B solutions simplify the payment journey so businesses can access working capital and increase B2B sales while reducing time consuming operational work.
Selling B2B with Buy Now, Pay Later can be incredibly complex. But it doesn’t have to be. With Two, you can increase conversion rates and average order value while eliminating admin and offsetting credit risk.
Whether you want to supercharge your B2B e-commerce checkout, optimise your trade account for frictionless customer onboarding, or offer B2B BNPL on all sales channels - Two is here to help.