Debt factoring is the term for a financial transaction in which a company sells its accounts receivable to a specialized finance company. Accounts receivable are sold at a discount and the finance company, known as the factor, is responsible for collecting the outstanding amounts. This is sometimes called accounts receivable financing or factoring.
Companies use this type of arrangement to improve cash flow and shorten the cash cycle. The business can receive immediate cash from the factor and without going through the collection process. Before entering into a debt factoring agreement, there are several pros and cons to consider.
The main benefit of debt factoring is that it provides a quick method of financing. Instead of waiting to receive cash from customer accounts receivable, the business receives cash immediately from the factor. This can be important if the company needs cash to achieve financial growth. It can also be an alternative for companies wary of taking on debt or issuing shares to raise capital.
Bad debt protection is a potential benefit. This would only apply if the company has entered into a non-recourse factoring agreement. Under this type of contract, the factor assumes the risk of insolvency. In other words, if a customer’s account cannot be collected, the factor must absorb the loss.
Profitable collections are another potential benefit. By selling its accounts receivable, the company is effectively transferring the entire accounts receivable collection process. While the costs of these processes are effectively built into the discount at which receivables are sold, they can still be an attractive benefit for companies looking to save time or reduce the number of employees needed for administrative work.
Before entering into a debt factoring agreement, a company must also consider a number of disadvantages. The main disadvantage is the cost. Under a factoring agreement, the factor buys accounts receivable at a discount. Depending on the amount of the discount, a factoring contract can carry a very high cost of capital. This cost should be compared to the cost of other financing methods available to the business.
A second disadvantage is that when a company works with a factor, they are introducing an outside influence into their business. Since the factor will be responsible for collecting accounts receivable and may be responsible for amounts that cannot be collected, they may try to influence sales practices. This can include attempts to influence sales policies and timing, as well as the customers a company deals with.
Bad debt liabilities are a potential downside. This would be applicable if the company has entered into a resource factoring agreement. Under this type of arrangement, the business is responsible for amounts that cannot be collected from customers. The discount rate at which the factor purchases the accounts is typically lower, but this should be considered in light of possible bad debt charges.
Customer relationships are a final potential drawback. Since a third party will now deal directly with customers to collect amounts owed, this can have a negative impact on the customer’s perception of the business. This is especially true if the factor engages in aggressive or unprofessional practices in collecting receivables.
Debt factoring represents a complex business arrangement. It usually requires a long-term contract and the modification of some sales processes. When evaluating whether debt factoring is a good option for a business, both the pros and cons must be weighed to make an informed decision.