No matter how great your client relationships are, sometimes invoices are left unpaid right up to the last minute. But rather than letting outstanding invoices restrict expected cash flow, small businesses can make use of debt factoring – one of the simplest and fastest forms of finance for SMEs. In this guide, we’ll cover the basics of debt factoring so that you can decide if it’s a good fit for your company needs.
Debt factoring is when a business sells unpaid invoices to a third-party for a percentage of the amount due. This is also known as invoice financing, invoice factoring, or accounts receivable financing.
Imagine you send a customer an invoice for £3,000, which has net 30 payment terms, but you need that money now.
You reach out to a debt factoring provider and sell them the unpaid invoice for £2,800. They pay you £2,800 today, and when the £3,000 is received from the customer they receive the full £3,000. They earn £200, you’re able to access your cash early, and the transaction is complete.
Debt factoring is a great alternative to other quick business loans, and for some companies it can offer more reassurance over overall costs and fees as there’s no monthly interest to account for.
The “factor” in debt factoring is the funding provider buying your invoice from you, similar to any other lender or financial institution. As you might suspect, though, the process isn’t quite as simple as handing an invoice over and collecting your cash.
A factor will look at several elements of the transaction before deciding to purchase an invoice or settling on a percentage to charge. This will include things like the value of the invoice, the credibility of the customer that owes the invoice, and, of course, the credibility of your business.
Businesses have the option to sell all of their outstanding invoices at once, which can increase your chances of receiving cash from your invoices since you aren’t relying on the credibility of one customer.
The clearest benefit of debt factoring is that you get immediate access to your income. Invoices are generally sent with a generous due date, at least a month, which is a pretty significant gap between the sale and the revenue. Debt factoring can help you close this gap.
Once this gap has been closed, you can immediately invest that cash into other areas of your business. This is great for organisations that are looking to purchase a new asset and grow their business at speed.
Although not every invoice will be approved for debt factoring, the success rate for approval is quite high. If you worry you may not be approved by traditional lenders, or don’t have the time to invest in lengthy application forms, debt factoring is a simpler alternative.
As mentioned, a factor will only pay you for a percentage of an outstanding invoice, which means you will lower your projected revenue. This percentage can be anywhere from 2%-3%, all the way up to 20%.
Another drawback is that factors will need to reach out to your customers in order to receive the invoice payment from them. This means that your customers will be aware of the fact that you are using debt factoring, which could impact your brand image. If you want to sell your invoices without customers being aware, then you could consider invoice discounting – where you remain responsible for collecting final payment.
It’s important to remember that factors are not debt collectors. They are there to receive on-time funds from your customers, not to chase down unpaid amounts. If your customers do not pay their invoices on time, there’s a good chance that your factor will approach you for the owed payment. Make sure that you only sell invoices for customers who are known to pay invoices reliably.
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