External sources of finance come from outside the business. Debt factoring belongs to external sources of finance. When businesses need to use the money for a short period of time (less than one year), this creates the need for short-term finance.
4. Debt factoring
Although individual retail customers pay cash for any purchase, most businesses buy goods and services on credit. For example, when the business from the primary sector sells supplies to the manufacturer from the secondary sector on 30 days trade credit, the supplier will not receive any payments until the following month.
When a business organization sells products to the customers who buy now but pay later, those customers become Debtors to the business. Debtors owe money to the business and are shown as Trade Receivables on the Balance Sheet.
The longer the time allowed to pay up the invoice, the more short-term finance the business will need to meet day-to-day expenses and pay other short-term debts in order to carry on trading. And, Trade Receivables grow.
If a business gives too much credit to its clients, it faces a higher chance of bad debt. Bad debtors are those who are unable to repay the money owed, perhaps due to their own financial problems.
And now the business has a big problem what to do with so much bad debt.
Debt factoring is the process of a business selling its debt to a debt factoring company. The debt factoring company buys the unpaid invoice, so that the business can obtain immediate cash to finance its normal operation.
How does debt factoring help?
It is always a good practice to collect cash payments from customers once the product has been sold. However, the solution to this highly problematic debt collection issue is to sell these claims on Trade Receivables to the third party.
That third party is a debt-factoring company. And ‘selling debt’ becomes a financial transaction. The debt-factoring company buys those unpaid invoices for a discounted amount in exchange for cash. In this way, immediate cash is obtained by the business. This cash gives an immediate boost to improve liquidity.
Benefits of debt factoring
- Immediate access to cash. Debt factoring allows a business to raise funds based on the value owed by its Debtors, all the customers who have bought on credit. Most debt factoring service providers offer between 80%-95% of the outstanding payment within 24 hours once the application has been approved.
- Saves time. Chasing every debtor is extremely time-consuming, hence increased workloads. The debt factoring company takes over the legal responsibility of chasing up those Debtors.
- Improvements in Working Capital. Debt factoring is a way to finance Working Capital of the company by quickly turning Debtors (Trade Receivables) into Cash. It provides a large and quick increase in Cash Inflow of the business. This immediate cash influx can be very beneficial comparing to receiving money in 30-days’time, 60-days’time or 90-days’ time – typical trade credit periods.
- Trading with more reliable customers. Smaller firms which sell products on credit often hire specialist debt factoring firms to make the credit agreement with customers. Debt factoring companies are responsible for checking the credibility of every customer which helps the business to trade only with reliable customers.
Drawbacks of debt factoring
- High fees. Debt factoring providers will charge high fees for chasing Debtors. There are also additional charges for management, administration and maintenance of final accounts. The larger the value of debtors, the higher the charges tend to be as there is increased risk involved.
- Current Assets will decrease. The amount of Current Assets will decrease on the Balance Sheet by around 5%-20% as debt is sold at the discount to the debt factoring company.
- Not applicable to small businesses. Not all businesses are eligible to use the debt factoring services, especially small unknown firms. Many debt factoring providers are only willing to work with large public limited companies that have high market power.
- Company image distortion. In the past, debt factoring was often considered as a sign of financial difficulties. The business was seen as an organization that is not able to collect payments from its customers on time. However, in recent time, the perception has changed and many businesses use debt factoring services to manage the whole process of debt collection from their customers.
How debt factoring companies make profit?
The debt-factoring company’s profits are made by discounting the debts and not paying their full value to the business. The debt-factoring company gains a profit at the time when it will receive the full payment from the original customer (Debtor). Only a proportion of the value of the debts will be received by the business as cash, not the full amount of the debt.
In summary, debt factoring can act as an immediate source of finance for all of those businesses that have cash flow problems caused by many unpaid invoices.
