Debt factoring is the term for a financial transaction in which a business sells its accounts receivable to a specialized finance company.
The receivables are sold at a discount and finance company, known as the factor, has the responsibility of collecting the outstanding amounts.
This is sometimes referred to as accounts receivable financing or factoring.
This type of arrangement is used by businesses to improve cash flow and shorten the cash cycle.
The business is able to receive immediate cash from the factor and without carrying out the collections process.
Before entering into a debt factoring agreement, there are several pros and cons to consider.
The primary benefit of debt factoring is that it provides a quick method of financing.
Instead of waiting to receive cash from customer accounts receivables, the business receives cash immediately from the factor.
This can be important if the business needs cash to pursue finance growth.
It can also be an alternative for businesses wary of taking on debt or issuing equity to raise capital.
Protection from bad debts is a potential benefit.
This would only apply if the business has entered into a non-recourse factoring agreement.
Under this type of agreement, the factor assumes the risk of bad debts.
In other words, if a customer account cannot be collected, the factor must absorb the loss.
Cost effective collections is another potential benefit.
In selling its accounts receivable, the business is effectively handing off the entire process of accounts receivable collections.
While the costs of this processes are effectively built into the discount for which the receivables are sold, it can still be an attractive benefit for companies looking to save time or reduce employees needed for back office work.
Before entering into a debt factoring agreement, a business must also consider a number of disadvantages.
The primary disadvantage is cost.
Under a factoring agreement, the factor purchases accounts receivable at a discount.
Depending on the discount amount, a factoring agreement may imply a very high cost of capital.
This cost must be compared to the cost of other methods of financing available to the business.
A second disadvantage is that when a business 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 which 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 that a business with deal with.
Bad debt liabilities are a potential disadvantage.
This would be applicable if the business has entered into a resource factoring agreement.
Under this type of arrangement, the business is responsible for any amounts that cannot be collected from customers.
The discount rate at which the factor purchases the accounts is usually lower, but this must be considered in light of potential charges for uncollectible accounts.
Customer relations are a final potential disadvantage.
Since a third party will now deal directly with customers to collect amounts owed, this can have a negative impact customer perception of the business.
This is especially true if the factor engages in aggressive or unprofessional practices when collecting receivables.
Debt factoring represents a complex business agreement.
It usually requires a long term contract and the modification of some sales processes.
When evaluating whether debt factoring is a good choice for a business, both pros and cons must be weighed to make an informed decision.