Debt Factoring: What is it, and how can it help?

Debt factoring, also known as invoice factoring or accounts receivable factoring, is an alternative source of working capital funding. It is not a loan. Business owners sell their outstanding invoices to a third-party known as a factoring company (“factor”) and receive an immediate advance as a percentage of the invoice amount.

Debt factoring is widely used by small and medium-sized companies to accelerate cash flow to pay operating expenses, pursue a growth opportunity, or purchase inventory and supplies to fill customer orders. Some companies decide to factor their accounts receivable because of a pressing financial obligation or when their customers require extended payment terms.  It is faster, more flexible, and easier to obtain than a loan.

How Debt Factoring Works

The debt factoring process is straightforward and easy for any size business to use.

  • You invoice your customer as usual for the goods or services rendered to that business.
  • You set up an account with the factoring company of your choice.
  • The outstanding invoices/ progress payments for work completed are submitted to the factoring company for verification with your customer.
  • The factor reviews the invoices and once verified/ approved, transfers an advance amount to your bank account.
  • The invoice amount is collected by the factor directly from your customer when due, which is usually 30 to 60 days.
  • The factor issues a rebate for the remaining invoice balance, less the factoring fee, to your bank account.

Types of Factoring

Factoring can be a program to purchase all of your eligible accounts receivable, so you have continuous and reliable cash flow. The factoring company works with you and your customer to develop a seamless process that dovetails with your business model.

In some situations, single-invoice factoring, more commonly known as “spot factoring,” may be a better solution. This is particularly useful for business owners that have a reliable cash flow stream but occasionally have a large invoice that would disrupt cash flow if they needed to wait 60+ days for payment. In these cases, you can use factoring to convert a single invoice to cash to fill the gap in your cash flow. This is the ideal solutions for businesses simply in need of immediate cash.  There is no multi-year contract required.

The most common form of factoring is recourse factoring. Recourse factoring requires business owners to purchase back any non-performing accounts receivable. This means that your business is ultimately responsible for the payment of the customer invoices if they remain unpaid past their due date.

However, with non-recourse factoring, the factoring company assumes the credit risk and liability of non-payment on the factored invoice. Since the credit risk is borne by the factoring company advance rates may be lower and factor fees may be higher when compared to recourse factoring.

Regardless of the type of factoring you choose, there are a number of advantages that make it a better solution for working capital funding for many small and medium-sized businesses.

Advantages of Debt Factoring

There are a number of advantages to debt factoring that make it an excellent solution to fund working capital needs, including but are not limited to:

  • Accessibility to cash flow: When you utilize debt factoring, you have immediate access to business funding. You don’t have to wait 60+ days to be paid, and there is no need to chase customers for payment. Cash flow is available to pay for things such as operating expenses, a business growth opportunity, or for the purchase of inventory and supplies to fill customer orders.
  • Flexibility: Debt factoring is more flexible than other business funding solutions. Factoring programs can be custom tailored to fit your company’s business model. Factoring companies work with you to dovetail transactions with your business processes. You don’t have to do work arounds to fit your business processes into a one-size-fits-all transaction.
  • Easier to obtain than loans: Loans can take weeks or even months to be approved and closed, and credit approval is based on your company’s financial strength and collateral. With debt factoring, credit approval is primarily based on your customer’s financial strength and credit history, instead of your company’s credit profile. As a result, the approval process is easier and faster than a loan.
  • Reduces the need to draw on existing credit facilities: Utilizing debt factoring instead of drawing down upon existing bank lines of credit or other credit facilities leaves them available to fund other working capital requirements. Adding debt factoring to your mix of business funding resources expands available working capital funding, and avoids the need to increase existing credit facilities during a business downturn.
  • Makes it possible for you to pursue new business opportunities: With debt factoring you can pursue new business opportunities that might not otherwise be possible if a loan is required. New business opportunities can arise at any time, even during a business downturn. Debt factoring can be used to quickly convert accounts receivable to cash to pay the operating expenses and buy the inventory and materials to fill a new order.
  • Can be combined with purchase order (PO) financing: Debt factoring can be combined with PO financing to provide seamless business funding of a transaction from the purchase of pre-sold inventory through the conversion of accounts receivable to cash. You don’t have to wait to buy the inventory needed to fill and order. Instead, you can fund the purchase of inventory and pay for the inventory with proceeds from the customer’s invoice when the order has been delivered.
  • Reduces credit and collection costs: With debt factoring, you can reduce credit and collection costs. The factoring company follows up with your customer for payment, allowing you to conserve resources to grow your business.

It is important to understand that not all factoring options are alike.  Capstone knows that every business is unique with its challenges, and each deserves an individualized approach to solving their cash flow shortfalls. With flexible factoring structures, Capstone will customize a program specific to your business that will help you achieve your business goals. By utilizing debt factoring, you can shift your focus from waiting on cash to working on your next project without the stress of inconsistent cash flow.

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