What Is Debt Factoring?
Debt factoring, perhaps more commonly known as invoice factoring, is a form of business financing in which business owners sell their unpaid invoices to a third party, typically called a factoring company, in exchange for most of the value of the invoices in advance of customer payment.
Unlike invoice discounting, also called invoice financing, debt factoring involves the sale of a business’s accounts receivable, as opposed to borrowing money against your invoices. In addition, when you enter into a debt factoring agreement, the factoring company then becomes responsible for collecting payments on your invoices from your customers.
With fast access to capital and flexible qualification requirements, debt factoring is a popular way for B2B and service-based businesses to mitigate cash flow issues.
This being said, considering all of the small business loans available on the market, is debt factoring right for your business?
Use our guide to learn everything you need to know about how debt financing works in order to determine if it’s a suitable form of financing for your needs.
How Does Debt Factoring Work?
Debt factoring—or factoring, in general—is the process in which you, the business owner, sell your accounts receivable (or outstanding invoices) to a third party in exchange for a percentage of the value of those invoices.
These third parties, usually called factoring companies or factors, will advance you anywhere from 70% to 90% of the value of your invoices. You’ll receive this capital in a matter of days—with the remaining percentage distributed to you (minus the factoring company’s fees) once your customers have paid their invoices.
Factoring companies typically charge their fees as factor rates (also called discount rates or factor fees). These fees normally range from 1% to 3% of the value of the invoice(s) and are charged for each week that it takes for your customers to make their payments. In addition, some companies will charge a processing fee at the point of sale.
This being said, as we mentioned briefly above, after you’ve sold your invoices to the factoring company, that company then becomes responsible for collecting on those payments—one of the biggest differences between debt factoring vs. invoice discounting.
Overall, because invoices often have net terms of 30, 60, or 90 days, debt factoring gives you access to capital that it may take weeks or months to receive otherwise—thereby freeing up your cash flow for use in your business.
Debt Factoring Example
To get a better sense of how debt factoring works, let’s walk through an example.
Let’s say you have a supply company and are currently waiting on payment for a $100,000 invoice. You’d like to free up your cash flow to make payroll, pay your bills, etc., so you decide to work with a factoring company to receive 80% of the value of your invoice immediately.
The debt factoring company purchases your invoice and transfers you $80,000 in a few days. The company will charge a 2% factor fee for every week it takes your customer to pay the invoice.
Luckily, it only takes your customer one week to pay, so of the remaining 20% of the value of your invoice ($20,000), you receive $18,000.
In other words, 2% x $100,000 = $2,000—and then, $20,000 – $2,000 = $18,000.
Overall, then, of the $100,000 invoice, you’ve received $98,000. Although you’re losing some profit, you had access to the capital more quickly—when you needed it.
If, however, the factoring company had charged a processing fee of 3% at the point of sale—you’d only be receiving $77,000 upfront, with the remaining $18,000 after your customer paid the invoice. In this case, you’d only get $95,000 out of the total $100,000.
All of this being said, with either of these debt factoring examples, you’re paying a total of $2,000 or $5,000 in fees—which may not seem like much at first—however, if you calculate these fees into an APR, you’ll find that you’re actually paying a steep pricing for this type of financing.
In the first example (with no processing fee), your APR is 104%, and in the second, 260%.
Debt Factoring vs. Invoice Discounting
In order to truly understand how debt factoring works, it’s important to differentiate between debt factoring and invoice discounting.
Compared to debt factoring, invoice discounting involves working with a lender or financing company to borrow money against your outstanding invoices. In this way, invoice discounting, or invoice financing, is much more akin to a traditional business loan or line of credit—once your customer pays the invoice, you’ll repay the lender the amount they loaned you, plus the fees they charge.
This being said, much of the confusion surrounding debt factoring vs. invoice discounting is the use of the word “discounting,” as debt factoring is often described as selling your invoices or accounts receivable at a discount.
For this reason, therefore, it’s much easier to refer to invoice discounting as invoice financing, as the two terms are equivalent.
With debt factoring, the factoring company is purchasing your accounts receivables and thus becoming responsible for collecting on the debt. In comparison, with invoice financing, you retain ownership of your receivables, and therefore, are responsible for collecting payments from your customers.
Use our invoice factoring vs. invoice financing guide for more information on the nuanced differences between these two arrangements and a comparison of the advantages and disadvantages of each.
Types of Debt Factoring
Now that we’ve reviewed all of the details regarding how debt factoring works, let’s break down the different types of debt factoring. Overall, each of these types of debt factoring will essentially work the same—as we’ve described above.
However, there are different arrangements that you can make with your factoring company (or that they offer) that constitute these unique types of factoring.
A recourse factoring arrangement means your business is responsible in the event that your customer doesn’t pay the factoring company for the invoice they owe.
Say, for instance, the client in our example above never paid their $100,000 invoice and the factoring company can’t collect on the debt. Then, with a recourse factoring agreement, you’re responsible for paying the entire invoice—$100,000—back to the factoring company.
As you might expect, this type of debt factoring is advantageous for factoring companies—as it mitigates the risk they’re taking by factoring your receivables.
Generally, therefore, you’re likely to find most companies offer recourse factoring arrangements.
Non-recourse factoring, as the name implies, is the opposite of recourse debt factoring. In this case, if a customer doesn’t pay their invoice and the factoring company can’t collect the debt—the company itself is responsible for that bad debt.
Therefore, with non-recourse factoring, you’re not liable for the debt even if your customer doesn’t pay. Compared to recourse factoring, it’s less common to find a company willing to offer non-recourse terms—and those that do will likely charge higher factor rates.
Whereas recourse vs. non-recourse debt factoring refers to the liability associated with bad debt, whole-turnover factoring refers to the number of invoices that you sell to a factoring company.
In a whole-turnover factoring arrangement, you sell all of your invoices to the factoring company you work with and the company purchases each invoice as soon you issue it. With this type of debt factoring, you’re ensuring a steady cash flow, which can be useful as startup funding, as well as if you have had cash flow problems due to late invoices in the past.
Keep in mind, though, consistently factoring your invoices also means you’ll be paying significantly in factor fees.
Compared to whole-turnover factoring, selective factoring means that you select which of your invoices you’d like to factor. In this arrangement, you have much more control over your financing and access to capital, and you also save on fees that add up with whole-turnover factoring.
Additionally, whereas whole-turnover factoring might be advantageous for businesses that have customers with a history of late payments, selective factoring will likely work better if you know that the customers associated with the invoices you select pay their bills on time.
Finally, spot factoring is when you sell a single invoice to a factoring company. Therefore, instead of agreeing to a factoring relationship—like the ones in these other types of debt factoring—you’re making a one-time transaction with a factoring company.
As you might expect, spot factoring is beneficial to businesses, as you can receive an advance of capital without having to commit to a monthly or annual agreement. For the factoring company, however, this is a riskier form of accounts receivable financing.
Along these lines, you might find that a factoring company requires a minimum invoice amount to agree to spot factoring, or charges higher rates.
Cost of Debt Factoring
Considering the different types of debt factoring and the way this type of financing works, you might be wondering how much debt factoring costs.
Although we gave a little bit of insight into costs with our debt factoring example above, let’s break it down in greater detail.
Overall, there are a number of factors that contribute to the cost of debt factoring—from the factoring company you work with to the type of agreement to the payment history of your customers.
At the end of the day, as we saw in our debt factoring example above, the factor rates and fees you’re charged aren’t an accurate reflection of the total cost of debt—so you’ll want to use an invoice factoring calculator to estimate your APR to get a better sense of how much any debt factoring agreement will actually cost your business.
Advantages and Disadvantages of Debt Factoring
With all of this information in mind, you might have a sense of the most notable advantages of debt factoring, as well as some of the disadvantages. To help you evaluate whether this form of financing is suitable for your business, though, let’s review these pros and cons:
Advantages of Debt Factoring
- Solves cash flow issues: One of the biggest advantages of debt factoring—and one of the reasons it’s such a popular form of financing for B2B businesses—is that it solves cash flow issues by giving you access to the capital you need immediately, instead of having to wait for your customers to pay. For startups or any business that operates on a tight budget, it can be extremely helpful to have expedited access to this capital in order to pay bills, make payroll, purchase inventory, or take advantage of a new opportunity.
- Fast form of financing: Similar to our first point, another top benefit of debt factoring is that it’s fast. Unlike other types of business financing, which can take anywhere from weeks to months to access, you can usually apply and receive capital from a factoring company in a matter of days—which is particularly important if you have bills to pay now or a growth opportunity available immediately.
- Don’t have to worry about collecting payments: One of the most noteworthy advantages of debt factoring, especially in comparison with invoice financing, is that the burden of collecting payments from customers falls to the factoring company. Therefore, instead of having to devote time and resources to this process, you have a third party handling it.
- Can be very affordable if customers pay on time: Although this isn’t always the case, debt factoring can be particularly worthwhile if your customers pay their invoices on time and you only have to pay minimum fees. Additionally, if you have a non-recourse funding agreement, another significant advantage related to payment is that you’re not responsible if your customers fail to pay.
- More accessible than other forms of financing: Whereas other common forms of business financing, like term loans or lines of credit, can have stricter requirements for eligibility, debt factoring is much more accessible to a wider variety of businesses. In short, because you’re selling your invoices to the factoring company, the invoices themselves serve as collateral on your agreement. In this way, factoring companies are much more likely to work with startups and businesses with bad credit (compared to traditional business lenders), as long as you have customers with reliable payment histories.
- Fills a very specific financing need: Although you might turn to any number of financing solutions to access capital to grow or fund your business, debt factoring fulfills a very specific need for certain types of businesses. Instead of having to take out a loan and then pay it back over time with interest, a debt factoring agreement can be a much more advantageous form of financing for businesses with capital tied up in unpaid invoices.
Disadvantages of Debt Factoring
- Can be expensive: Although debt factoring might be worthwhile if you need access to capital fast, and your customers pay on time, on the whole, it’s an expensive form of short-term financing. As we explained in our debt factoring example above, factor rates can translate into APRs over 100%—much higher than you see with other types of financing. Additionally, because the debt factoring “term” depends on how long it takes your customer to pay, it’s more difficult to evaluate the cost of this type of funding upfront.
- Interrupts your relationship with your customers: Perhaps one of the most notable debt factoring disadvantages is that by working with a factoring company, you’ve added a third party to your relationships with your customers. This might not necessarily be too problematic; however, many business owners are averse to changing the relationships they’ve built with customers. Similarly, some business owners feel that their customers knowing they’re working with a factoring company suggests that they’re in financial trouble.
- Can require an ongoing agreement: As we’ve discussed, some factoring companies will require that you enter a long-term agreement with them—whether this means agreeing to a certain length of time or a monthly minimum of invoices. Not only does this mean you’ll be continuously receiving less than the total value of your invoices, but it also puts you into a factoring cycle that can be difficult to break.
- Lost profits: Even though a top advantage of debt factoring is fast access to capital, on the other side of the coin, a huge disadvantage is that by working with a factoring company, you’re losing out on the total amount of profits you’re earning. Although the speed might outweigh the cost, this is not always the case—and something to keep in mind.
- Risky if your customers don’t pay their invoices: Most debt factoring agreements are likely to be recourse—meaning you’re responsible if your customers don’t pay their invoices. This can be a huge risk that you’re taking on as a business, especially if you already have cash flow issues.
Only an option for businesses with capital tied up in unpaid invoices: Again, although the specificity of this type of financing is a large advantage for certain businesses, it’s a disadvantage for others. When it comes down to it, if your business doesn’t invoice customers, or doesn’t have capital tied up in unpaid invoices, this type of financing won’t be available or useful to you.
How to Get Debt Factoring
If in comparing these advantages and disadvantages, you decide that debt factoring is a viable funding solution for your business, your next step will be to find the right factoring company to work with.
First and foremost, you’ll want to ensure that any factoring company you consider is trustworthy and reliable. You can research the company, read reviews, talk to their representatives, and even consult previous customers, if possible.
Additionally, you’ll want to look for a company that offers debt factoring that you can qualify for, as well as one that offers the type of agreement you’d prefer.
As an example, for an invoice factoring company that’s fast, accessible, and affordable, you might consider BlueVine. BlueVine can offer factoring in as fast as 24 hours, with amounts up to $5 million, up to 90% of the value of your invoices. Plus, BlueVine allows you to retain relationships with your customers by giving them the ability to pay their invoices to your BlueVine account.
Learn more about BlueVine in our review.
On the other hand, if you’re looking for a monthly factoring arrangement, you might work with altLINE, which requires that businesses factor at least $15,000 per month with them. Like BlueVine, altLIne is fast—with funding in as few as 48 hours. Additionally, with a minimum credit score of 500, altLINE is extremely accessible for businesses with little or poor credit histories.
Learn more about altLINE in our review.
Once you’ve found the factoring company you’d like to work with, you’ll be able to submit your debt factoring application. Most factoring companies will allow you to complete a streamlined application online with minimal documentation.
Then, if you qualify, you’ll receive an approval from the company with information about your agreement. You’ll want to review this agreement thoroughly to ensure you understand all of the fees, terms, and processes associated with your debt factoring.
After you sign the agreement, you’ll typically be able to receive your funds in just a few days. Overall, in comparison to other types of business financing, debt factoring is fast to fund—with most companies funding businesses in less than a week (and as quick as one day).
At the end of the day, if your business is looking to improve cash flow and currently has capital tied up in unpaid invoices, debt factoring might be an excellent solution for you.
As we’ve discussed, there are both advantages and disadvantages to this type of financing—however, it’s certainly worth considering for B2B, service, and other businesses that invoice their customers.
Of course, debt factoring won’t be best for every business or every financing need. Therefore, if you don’t think debt factoring is the right option for your business, you might consider other types of small business loans.
Randa Kriss is a senior staff writer at Fundera.
At Fundera, Randa specializes in reviewing small business products, software, and services. Randa has written hundreds of reviews across a wide swath of business topics including ecommerce, merchant services, accounting, credit cards, bank accounts, loan products, and payroll and human resources solutions.