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Published 14 February 2024
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10 minutes

What is Debt Factoring and How Does it Work?

Debt factoring is where a business essentially sells its unpaid invoices to a third party, which collects the outstanding funds on the seller’s behalf. It allows businesses to quickly access money tied up in unpaid invoices in return for paying fees to the factoring company.

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Debt factoring is a way for businesses to quickly access a portion of the money tied up in their unpaid invoices. With debt factoring, companies essentially sell their outstanding invoices to a factoring company, which pays a chunk of this value up front. The factoring company then assumes responsibility for collecting customers’ debts and charges a fee for its services. 

Since debt factoring frees up money that may not otherwise be paid for weeks or months, it can be used to manage cash-flow issues or fund business growth, for example. Like all business decisions, however, there are advantages and disadvantages to debt factoring, and these should be carefully considered before you decide whether debt factoring is right for your company.

What is debt factoring?

Debt factoring is when a business sells its unpaid invoice debts to a third party – either a dedicated factoring company or a financial services provider with a factoring division. The factoring company pays a sum of money up front, commonly around 80% to 90% of the value of the invoices. This quickly frees up capital for the business, which no longer has to wait for those invoices to be paid according to its usual terms. This upfront payment is sometimes referred to as an advance. 

If your business enters into a factoring arrangement, then instead of your customers paying you directly, the factoring company will collect your customers’ payments on your behalf. Factoring may cover a single invoice (known as spot factoring) or may be an ongoing arrangement, with the factoring company collecting debts from multiple customers over a longer period of time.

In return for releasing the advance, the factoring company charges a fee – known as a discount rate or a factor rate. The factor rate may range from 0.5% to 7% of the total value of the invoices you’re selling and is likely to be charged on a weekly or monthly basis until the factoring company has been paid by your customers. Some factoring companies may charge other fees, such as service fees and collection fees, on top of the factor rate. 

When your customers have settled their outstanding invoices, the factoring company will pay you the difference between the value of the invoices and how much they paid you up front, minus fees. Ultimately, your business gets paid quicker, but you will end up receiving less money than if you had simply waited for your customers to pay their invoices.

Debt factoring is different from debt financing. Debt financing is when a business raises funds by borrowing money, which it must later pay back with interest. With debt factoring, a business releases funds locked up in unpaid invoices by selling those invoices to a factoring company. Assuming your customers pay what they owe, you will not have to repay the money advanced to you by the factoring company. 

How does debt factoring work?

As a simplified example of how debt factoring works, imagine your business has just invoiced a customer for £10,000. A factoring company may offer to advance you 85% of the value of this invoice within a couple of business days. Let’s say it charges a factor rate of 2% of the total invoice amount every week until the customer pays.  

In this case, your business will receive 85% of £10,000 up front, which is £8,500. The remaining 15% of the value of the invoices (which comes to £1,500) will be kept in a reserve account by the factoring company.  

The weekly factor rate is 2% of £10,000, which means you’ll be charged £200 in fees every week until your customer pays. If your customer pays after three weeks, then the total factor rate will be £200 multiplied by three, which is £600. 

The factoring company will deduct their fees – totalling £600, in this case – from the £1,500 they are holding in reserve, leaving £900. This will be paid back to your business as the difference between your advance payment and the value of the invoice, minus fees. So your business sold an invoice worth £10,000 and received £9,400 – most of which was paid up front. 

Remember that there may be additional costs to pay on top of the factoring rate, such as set-up and service fees.

What is invoice factoring?

Invoice factoring is just another term for debt factoring. The two terms mean the same thing, and you may find that they are used interchangeably.

What are the advantages of debt factoring?

Debt factoring can help with cash flow

Because debt factoring frees up money that would otherwise be tied up in unpaid invoices, debt factoring can help with cash flow. The capital advanced to a business can be immediately reinvested or used to cover business expenses. And because debt factoring isn’t a loan, the money it frees up usually doesn’t have to be paid back.

Debt factoring can save you time

When your business sells its unpaid invoices to a factoring company, the factoring company generally assumes responsibility for collecting payments from your customers. This means you no longer have to worry about chasing customers and handling their payments. Instead, you can focus time and resources on other areas of your business.

Debt factoring provides fast access to capital

When a factoring company buys your unpaid invoices, it will generally pay your advance very quickly. Some factoring companies pay within just 24 hours of receiving an application. This can be helpful if your business needs to improve its cash flow or free up capital urgently.

What are the disadvantages of debt factoring?

Debt factoring can be expensive

Factor rates may be as high as 7% of the value of your unpaid invoices over a pre-agreed time period. Rates are likely to depend on how many unpaid invoices you’re selling, how much they’re worth and how long it can take for a customer to pay the invoice. 

Generally, the greater the value of the invoices you’re factoring, and the fewer payments the factoring company has to collect, the smaller the factor rate. This means that if you’re looking to factor lots of smaller invoices, the rates may not be worth it for your business. 

Factor rates may also depend on which sector your business operates in. The factoring company may take notice of your industry, offering lower rates to sectors deemed ‘low risk,’ where non-payment of invoices is unlikely. If you operate in a sector where there is a greater risk of non-payment, the factoring company may charge higher rates to balance out the perceived risk.

Factor rates will be charged weekly or monthly until the factoring company is paid by your customers. This means fees can rack up if your customers are slow in paying what they owe, and if your payment terms are generous. And bear in mind that some factoring companies may charge additional fees for their services on top of the usual factor rate. 

As factor rates and additional fees can vary, be sure to check the terms carefully before you enter into a factoring arrangement. Fees will vary from case to case, and you may find that fees and rates make a considerable impact on your profit.

Debt factoring reduces overall profit

Debt factoring frees up cash in the short term, but because factoring companies charge fees, this cash injection comes at the cost of longer-term profits. If you can afford it, it will generally be more profitable to wait for customers to settle their unpaid invoices than to sell your customers’ debts to a factoring company. 

Debt factoring is not suitable for all businesses

Debt factoring may not be an option if your business sells products or services directly to consumers. This business model is sometimes referred to as B2C – ‘Business to Consumer’.

Instead, debt factoring is best suited to businesses whose customers are other businesses. This is because ‘B2B’ businesses are more likely to invoice for their services. If your business doesn’t use invoices, you won’t be eligible for debt factoring.

A factoring company may also have other eligibility requirements. For example, it might want to see that your business has achieved a certain minimum turnover before it enters into a factoring arrangement. 

Debt factoring means giving up some control

When you let a factoring company take over the collection of unpaid invoices, you’re giving up control over this part of your business operations. Some may view this as a positive, but others may worry about a factoring arrangement disrupting or changing their relationship with customers. 

It is important to research factoring companies to make sure they collect payments in a professional and ethical manner. After all, they will be representing your business in all their dealings with your customers.

Debt factoring may make you liable for unpaid invoices

Recourse factoring is the most common kind of debt factoring. With recourse factoring, you become responsible for the money owed to the factoring company if, for whatever reason, your customers fail to pay their debts. 

With non-recourse factoring, the factoring company assumes responsibility in the event that your customers don’t pay. Non-recourse factoring usually comes with higher rates – and tougher acceptance criteria – than recourse factoring. 

Is debt factoring right for your business?

Your business will only be eligible for debt factoring if you invoice your customers. This is why debt factoring is more likely to be used by B2B businesses, whose customers are other businesses. 

But because debt factoring can be expensive, it may not be right for your business if you can afford to simply wait for customers to pay their invoices. And if your business is small, you may not meet the minimum turnover requirements factoring companies set. Even if your business does need a cash injection, you may be better off seeking other forms of financing, which could work out cheaper in the long run. 

Alternatives to debt factoring

Before deciding whether debt factoring is right for your business, consider researching other forms of business finance. Other types of business loans may also allow you to quickly access capital without having to wait for your customers to settle outstanding invoices.

Small business loans

Debt financing may be more suitable for your business than debt factoring. Debt financing involves borrowing money – through small business loans or other financing options – which you will have to pay back.  

Small business grants

Business grants, which don’t have to be paid back, can provide money to pay for training, growth or research and development, for example. Small business grants may be provided by government bodies, educational institutions, or commercial organisations.

Equity financing

Equity financing is where you raise money by selling shares in your business. This can generate an injection of capital which you do not have to pay back. However, you will have to give up a portion of your business to your investors.

Asset finance

Asset finance is a loan taken out by a business to pay for expensive assets – such as cars, machinery, or office equipment. Through leasing or hiring arrangements, asset finance can help you spread the cost of this equipment over the long term, saving you from paying huge costs up-front.

Government business loans

Government business loans are much like any other loan. If you take one out, your business will receive an injection of capital, which must be paid back over a pre-agreed term with interest. The only difference is that in this case, the government plays a role either by making capital available or by providing guarantees to lenders in the event of non-repayment. Usually, UK government business loans are offered by British Business Bank-accredited lenders.

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