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Debt Factoring

Debt Factoring vs Account Receivable Financing: What To Choose?

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Uninterrupted cash flow is the lifeline for all businesses; however, it is not uncommon for companies to have considerable gaps between a sale and receiving payment, which can disrupt their liquidity.

As a result, ensuring smooth cash flow can be quite challenging for businesses, especially the ones that allow long credit periods to their customers. Also, these piled-up receivables can result in a severe cash crunch and snowball into other business-threatening issues.

As per Entrepreneur report, more than 80% of businesses fail due to lack of cash; 20% of small businesses fail within the first year, while half fail within 5 years.

In this situation, debt factoring and accounts receivable financing are two options that can help businesses balance their liquidity and credit sales for smooth day-to-day operations.

While both are excellent short-term finance options, they differ in a few aspects. In this blog post, this is going to be our key topic.

What is Debt Factoring: An Outline

Debt factoring, also known as invoice factoring, is a finance instrument that converts outstanding invoices to immediate cash. This option allows a business to sell its accounts receivables to a “factor” (third party) at a discount. The factor pays a pre-determined percentage of receivables upfront and takes up the responsibility of collecting the dues from the customer on the due date.

The factoring company usually pay 75%- 90% of the invoice in advance and the remainder after collecting the dues from the customer. After collecting the payment from the customer, they pay the business the remaining amount after deducting their fees.

Debt factoring helps businesses stabilise their cash flows without compromising on customer relations. The firm need not hesitate when extending credit to their customers or wait for customers to pay, and they need not hesitate when extending credit to them. With invoice factoring, they can unlock the funds tied up in the unpaid invoices and use them for their day-to-day functioning.

What Is Account Receivable Financing?

Accounts receivable (AR) financing is also a short-term finance option that uses outstanding invoices to fund growth. Like debt factoring, AR financing provides the business with an alternative to the traditional line of credit to manage its cash flow requirements.

AR financing is asset-based lending; the invoices act as collateral against which the lender, usually a bank, lends funds to the business. The firm retains the ownership of its accounts receivables.

Generally, lenders lend up to 75% to 85% of the AR value to the business. Lenders charge interest on the loaned amount until the business repays the entire amount.

This is to note that companies generally do not use all their accounts receivables for financing; businesses decide which customer’s invoice they want financed, but they do not choose which specific invoices.

What is the Difference Between Debt Factoring and Account Receivables Financing?

Debt factoring and account receivable financing unlock the funds tied up in invoices, which impact the working capital availability of a business. However, these two finance options differ in the following five aspects:

  • Ownership

A fundamental difference between debt factoring and account receivable financing is ownership of the invoices. In the former option, the ownership is transferred to the factor, and the customer pays the dues directly to them. In AR financing, the business retains the ownership of the invoices and is responsible for collecting the dues.

  • Costs associated with financing

When a firm chooses the AR financing option, it pays a fee for the service, usually a percentage of the invoice value. The factoring option requires the business to pay interest on the outstanding amount and a fee for the service.

  • Invoice value

No minimum invoice value is fixed for the AR financing option; a business can get even small invoices financed. Regarding factoring, lenders are willing to finance invoices above a minimum amount. This means a firm can get only larger invoices financed.

Lenders can manage and track their loans more efficiently with solutions like Finezza’s Loan Management System and service their customers better.

  • Eligibility requirements

Eligibility requirements for both options also differ. Lenders are willing to finance ARs if the business has a good credit profile and a strong financial position. For the factoring option, the customer should have a good credit history and be in a position to pay their invoices on time.

  • Time taken

Factoring is a quicker financing option; it usually takes 24 hours to obtain the funds. Invoice financing has a longer turnaround time, and a business might have to wait for days or weeks to get the funds.

The table below gives a snapshot of the differences between the two.

Difference between Debt Factoring vs Account Receivable

Debt Factoring or Account Receivable Financing: Which Is Better?

As the discussion reveals, both debt factoring and account receivables financing help a business manage its cash flow requirements. So, how does a firm choose the right option for them?

Below are four aspects firms should consider when making a choice.

  • How fast do they need the funds?

Both options are faster when compared to traditional business loans. However, debt factoring allows quicker access to funds, so if a business needs funds quicker, then factoring is the right choice. If they can wait for a while, then account receivable financing could be an option for the business.

  • How much funds do they need?

Debt factoring offers a higher percentage of the invoice’s value to the business than AR financing; thus, it provides a firm with more funds vis-a-vis invoice financing.

  • How much are they willing to pay in charges and interest?

Account receivables financing is comparatively less expensive as compared to invoice factoring.

  • What is the credit score?

Account receivable financing norms are stricter; hence, lenders are willing to approve financing only for customers with good credit profiles.

Debt factoring offers more funds to a business, faster access and may be suitable for firms with a high volume of invoicing, though it may cost more compared to AR financing.

Conclusion

For a business considering debt factoring or account receivable financing as options for cashflow management, it is advisable to compare both options and also get quotes from different lenders to compare costs and other terms.

However, one size never fits all; thus, each business needs to look at its requirements before it makes a choice. There may be situations when invoice factoring may be more suitable for a business, and on other occasions, invoice financing may work better for the same firm.

Web-based Lending Lifecycle Management Platform Finezza offers solutions that leverage emerging technology like artificial intelligence and machine learning for efficient lending portfolio management.

Book a demo to know more.

Debt Factoring: Is It The Best External Source of Finance in the Short-Term?

Open Banking

It is hardly an overstatement to say that the mechanism of credit sales or deferred payments grease the wheels of trade and commerce.

Small and medium businesses, in particular, get a chance to stay ahead of the competition by providing such credit purchase facilities to their customers.

This often allows them to cultivate long-term relationships with their clients based on trust. However, credit sales can jeopardise a small firm’s liquidity through inconsistent cash flows and consequent cash crunches.

This blog will focus on debt factoring and how business owners can leverage it as quick-fix finance.

Debt Factoring: An Overview

Debt factoring enables businesses to cash out their unpaid invoices upfront through discounting or factoring while offering their clients extended credit terms.

Businesses sell their account receivables at a discount to a third-party firm known as the factor and receive immediate payment. The factoring company will collect the invoice on the due date and pay the seller the balance after deducting the charges.

Debt factoring allows small, up-and-coming firms to stabilise their cash flows for fulfilling their routine payment obligations. It enables businesses to smoothly carry on their operations while building and maintaining credibility and reputation in the market.

Reprising the Fundamentals of Debt Factoring

Credit sales arrangements establish a debtor-creditor dynamic between the trading parties and the buyer-seller relationship.

Such payments become the accrued revenue for the seller and are accounted for under current accounts in their balance sheets. For the buyer, the transaction generates an account payable under current liability.

Money tied in invoices will negatively impact the working capital availability for the seller. The seller/creditor can raise money for its immediate requirements by selling the outstanding invoices to the third party, factor in part or whole.

This short-term mode of funding working capital is often convenient and hassle-free compared to conventional financing methods.

Types of Debt Factoring

Debt factoring is synonymously called accounts receivable factoring or invoice factoring. Based on the technicalities, there are various types of debt factoring, such as:

 

  • Maturity and advance factoring 

In maturity factoring, the seller of goods and services receives the payment of the invoices from the factor on the due date of the invoice or any other predetermined date as per the sales contract with the factor. It is also called collection or wholesale factoring.

In advance factoring, the factor pays the seller for the invoices earlier than their due date. Usually, a percentage (75%- 90%) of the invoice is paid in advance and the balance is paid upon realisation of the dues from the debtor. The factor will charge a fee for discounting the invoices.

 

  • Recourse and non-recourse factoring 

In debt factoring with recourse, the factor will not accept the credit risk if the buyer defaults on the invoices. In such cases, the seller must bear the losses.

In factoring without recourse, the factor absorbs losses resulting from nonpayment of invoices, and the creditor is not required to compensate the factoring firm for bad debts.

 

  • Disclosed and non-disclosed factoring 

Disclosed factoring is commonly known as notified factoring. As the name implies, the seller will notify the buyers about the engagement of the factoring firm and instruct them to pay the invoice directly to the factor on the due date.

The seller does not disclose the involvement of the factor in non-disclosed factoring arrangements. As a result, it is also known as a confidential factoring deal.

 

  • Limited factoring 

It is also called selective factoring. Here, the factor manages or pays selected invoices or invoices of specific clients instead of all unpaid bills of the seller.

 

  • Regular factoring and spot factoring 

The factoring firm and its client can choose to have an ongoing agreement for debt factoring or limit their business to a single transaction. The arrangement for continuous factoring of invoices with a client is called regular factoring. In contrast, spot factoring is a one-time deal.

 

  • Reverse factoring 

Reverse factoring differs from traditional factoring in that it is initiated by the buyer rather than the seller. It is popularly known as supply chain financing.

Debt Factoring: Viable Short-Term Funding Option for Businesses?

Debt factoring appears to be an ideal way for businesses to fund working capital without incurring too much debt in their financial records.

The approach benefits businesses by offering easy access to capital that boosts cash flows, is cost-effective, and primarily protects the companies from having to deal with the headaches of bad loans.

Debt factoring helps businesses to-

  • shorten cash conversion cycles and thereby hasten business cycles
  • reduce the time and effort needed for dedicated receivables management and credit control activities, and
  • allows for more accurate business planning and forecasting due to predictable cash flows.

Debt Factoring: Some Concerns  

On the flip side, debt factoring comes with some less favourable covenants, like:

  • Clawbacks from sales proceeds by way of charges, fees, and other administrative expenses
  • Chances of the third-party factoring firm influencing your business decisions as the factor have a voice in the selection of invoices to discount
  • Decrease in balance-sheet current assets, affecting liquidity ratios
  • Risk of reputation damage due to aggressive recovery methods by the factoring firm

However, as a funding method, the advantages of debt factoring far outweigh the drawbacks.

The Bottomline

For B2B businesses, debt factoring is the most practical working capital funding option. Its suitability for a specific business line is determined by the nature and type of operations, the frequency of invoicing, and the credibility of the firm’s clients.

Debt factoring becomes the best solution for ensuring stable cash flows for businesses with a high volume of invoicing.

Comparing the costs and advantages of factoring services to other financing modes is the best way to assess their suitability for your business. Understanding the benefits and drawbacks of factoring services will also help you to negotiate better terms and get the most out of a debt factoring agreement.

Finezza brings cutting-edge fintech solutions and analytic software for more promising lending portfolio management.

From the bank statement analyser to Account Aggregator(AA) framework and mobile ecosystems and APIs, our state-of-the-art solutions are everything you need to manage your processes effectively.

Contact us today!

References:

  1. https://www.dripcapital.com/en-in/resources/finance-guides/types-of-factoring

What Is Debt Factoring and Is It Right for Your Businesses?

Loan Origination System

Every small business owner begins by planning for success. However, in business, as in life, unforeseen events can throw a wrench into even the best-laid plans.

Unexpected expenses and slow-paying customers can cause cash flow to fall to dangerously low levels. While larger companies may be able to turn to more traditional solutions, such as a bank loan or line of credit, small business owners may not have those options.

This is where debt factoring comes into play. You can use debt factoring to sell your accounts receivable at a discount to a debt factoring company and receive a quick infusion of cash.

Let us dive deep into the topic.

How Does Debt Factoring Work?

Debt factoring is a financial transaction in which a business sells its outstanding accounts receivable (i.e., its customer invoices) to a third-party factor, at a discount, in exchange for immediate cash.

When your company decides to use debt factoring services, you will sell its outstanding invoices to a debt factoring company, either partially or entirely. You first offer your products and services to your customers and then bill them. These outstanding invoices are then sold to a third party, a debt factoring company.

The risk level will be determined by examining your debtor’s financial health. Debt factoring companies typically pay 80%-90% of invoice payments (usually between 80%-90%). Your clients’ funds are transferred directly to the third party, and you receive the outstanding balance once the factoring company receives the payments.

Here’s an example to illustrate how debt factoring works:

Suppose ABC Inc. provides goods and services to its customers and has $100,000 in accounts receivable. ABC Inc. faces a cash flow problem and needs money to pay its bills and employees and purchase raw materials.

It decides to factor its accounts receivable rather than wait 30, 60, or even 90 days for customer payment. A factoring company accepts ABC Inc.’s accounts receivable for $95,000.

In exchange for $95,000 in cash, ABC Inc. uses the factoring company to collect customer payments. Factoring companies accept customers’ payments and keep a small fee (usually 2-3% of the invoice amount)

With the help of a factoring company, ABC Inc. could access the cash it needed to continue operating without waiting for customers to pay.

Since factoring companies charge fees, debt factoring is usually used for short-term cash flow issues and is more expensive than other financing options, such as bank loans.

3 Key Advantages of Debt Factoring

Here’s a list of the advantages of debt factoring:

1. Increases cash flow

Cash is received as soon as the invoice is sold, providing greater control over investment and growth decisions and, as a result, improved business operations. This quick injection of cash can smooth over any short-term financial issues, allowing a business to survive in some cases.

2. Saves time and resources

Freeing up time is facilitated partly by improved cash flow and by releasing resources required when chasing unpaid invoices. It enables you to run the business more efficiently, focusing on growth and improved operations.

3. Enhances growth prospects

If the money received from the debt factoring company is wisely invested, it can result in tremendous growth. As the company’s growth improves and it can build a solid customer base with more funds available, it may reduce its reliance on debt factoring.

Some Disadvantages of debt factoring

  • Short-term debt

While debt factoring has many advantages, it causes the company to incur short-term debt. If the customer does not pay the invoice to the debt factoring company on maturity or if there is a dispute, the borrower is in debt to the financer.

  • No control over the sales ledger

As the debt factoring company assumes responsibility for chasing down invoice payments, the business loses some control over its sales ledger, as well as confidentiality and customer relationship.

  • Reduces profit and expensive

Debt factoring can also reduce your profit because you receive less than the total value of the invoice.

Is Debt Factoring Appropriate for My Business?

Debt factoring can be a good short-term financing option for B2B companies with unpaid invoices. In addition, it can be a profitable business for lenders since they can collect fees for the service provided to companies and earn interest on cash advances.

This type of funding can assist you in managing your cash flow, covering day-to-day expenses, and promoting business growth.

Startups and businesses with poor credit may consider debt factoring if they cannot qualify for other options and have outstanding invoices.

Summing up

A business’s decision about whether debt factoring is a good idea depends on the specifics of its situation. It can provide an organisation quick access to cash by selling its receivables to a third party at a discount. While this can help manage cash flow, it also requires the business to give up some of its outstanding debt.

The benefits of improved cash flow must be weighed against the costs of factoring, including the loss of control over customer relationships, fees, and interest rates that may occur. You must thoroughly research and compare different factoring companies and their terms before deciding which factoring company to choose.

Using FinTech has also made debt factoring easier. With digital platforms, lenders can reach a wide range of SMEs seeking financing and more effectively managing their investments. One such fintech solution is Finezza.

Finezza: Your Partner for Lending Lifecycle Management Platform and other services

Finezza’s cutting-edge suite of products, like the Loan Management System and  Collection Management System, meets the demands of today’s lenders with greater sophistication and customer-centricity. You can easily track loans, manage delinquency, and collect debts using this service, and you can always access vital debt collection information.

Book a demo today!