Understanding Debt Factoring for Small Businesses

Q: What is the difference between debt factoring and invoice financing?

With debt factoring, you sell the invoice to a third party company at a discount, and it takes control over collecting payment from the customer. Another thing unique with debt factoring is that many companies charge a weekly fee for each week the invoice is unpaid. While responsibility falls on the debt factoring company, it’s the small business that is penalized. Invoice financing, on the other hand, uses unpaid invoices as collateral. You are still responsible for collecting payment from the customer. Once your customer pays, you use the money to pay off the loan. Some business owners may prefer it over debt factoring because they keep total control over their company’s image.

Q: What are the disadvantages of debt factoring?

As discussed above, debt factoring has its share of disadvantages. The biggest drawback are the fees, which can eat into your company’s profit. The next drawback is that, because you are no longer in control of securing payment, your company’s image may be sullied by the third party company. Lastly, if you need the invoice for working capital, a short term small business loan may make more financial sense. You may pay less in fees and be able to borrow a larger amount.

Q: What is an example of debt factoring?

A company installed carpet for a 4,000 square foot office building, but has yet to receive payment on the $28,000 invoice. Because the project used up so much inventory, they are now having working capital issues. To rectify this so they can continue operations, they decide to utilize debt factoring. The debt factoring company gives them 80% of the invoice amount, which equals $22,400. However, they charge 5% for each week they are unable to receive payment. It takes two weeks for the customer to pay, which means the factoring company keeps $2,800 of the $28,000 invoice.

What is Debt Factoring for Small Businesses?

Lauren WardUpdated July 16, 2023

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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

Debt factoring describes a situation when a business works with a third party company to receive payment on unpaid invoices. The debt factoring company usually buys the invoice at a discount, but it provides the remaining amount once it is able to collect payment. As you may expect, there are fees involved, but if you’re having working capital issues, debt factoring may be a viable solution.

What Is Debt Factoring?

If you’re familiar with invoice factoring or accounts receivable factoring, debt factoring is another term for it. Factoring in business is when a company sells its unpaid invoices from its accounts receivables to another company at a discount. The remaining amount is paid once the third party company is able to collect payment, minus any fees it charges. Companies that make use of debt factoring often do it to shore up working capital issues. With debt factoring, they may be able to cover all of their operational expenses and make payments on their short term debts. However, it’s important to note when wondering “What is debt factoring,” that the top small business loans may be a better fit, especially when it comes to working capital. Recommended: Guide to Business Financial Planning

How Debt Factoring Can Help Small Businesses Manage Cash Flow

Debt factoring is best utilized as a boost to working capital. Companies that are having liquidity issues because of cash stalled out in accounts receivable can use debt factoring to help pay for any of its operating expenses and short term debts. While there are fees involved with debt factoring, the benefit of it is that the money obtained from it can be used to fund incoming orders and jobs. In other words, it can help keep business moving. Business owners strongly considering debt factoring should take the time to compare companies and fees. Each business charges differently for its services, so it is possible to save a lot of money by working with a different company.Recommended: Guide to Business Financial Planning

Improving Financial Stability With Debt Factoring

One of the strongest arguments that can be made in favor of debt factoring is that businesses are not taking on additional debt to rectify cash flow issues. This is certainly a strong argument in favor of it. Businesses having issues with working capital may not want to endanger its credit score and assets with a business loan if there’s a possibility it won’t be able to make the monthly payments. By working with a debt factoring company, they are keeping their finances relatively the same. For many small businesses, including new ones, this may be enough of a reason to work with a debt factoring company. On the flip side of this argument, just remember that you are losing a small percentage of the invoice to the debt factoring company through fees. While debt factoring can certainly help with working capital, you are reducing your overall profit each time you do it. Recommended: Income Statement in Business: What It Is and Why It’s Important

Debt Factoring vs Small Business Loans

One of the biggest cons to debt factoring is that it reduces a company’s profit because of the fees charged by the third party. Companies vary on what they charge, but a common fee is to charge a small percentage of the invoice amount for each week they are unable to receive payment. Depending on how ethical of a company they are, this may disincentivize them to pursue payment from your customers right away. Plus, many debt factoring companies charge other fees, such as ACH transfer fees or account management fees. The next thing you want to consider is customer perception. While some of your customers may not make their payments in a punctual manner, how will they feel knowing their account was essentially sent to a collection agency? Will this hurt your relationship with them? Many debt factoring companies are 100% professional and ethical, but some may not transmit that image. Before deciding which company to work with, make sure you read plenty of customer reviews. Another thing to consider is that debt factoring isn’t ideal for every company. Many businesses simply don’t revolve around invoices. For these companies, a small business loan may be the best option. If you are considering debt factoring to solve your working capital issues, a small business loan may be a better fit because:

You may save money in fees
You may be able to borrow a larger sum of money
It won’t affect your company’s image
You will still be in control of the invoice
You won’t lose money in profits

Recommended: Minimum credit scores for business loans

The Takeaway

Debt factoring allows a company to sell its unpaid invoices to a third party company at a discount. That company is then responsible for collecting payment. Once payment is received, any remaining invoice amount is forwarded to the business minus any fees. While there are certainly benefits to debt factoring, it may make more financial sense to pursue a small business loan. Not only may you be able to borrow a larger amount, but you might also save money in fees. Explore small business loans with Lantern by SoFi.

Frequently Asked Questions

What is the difference between debt factoring and invoice financing?

What are the disadvantages of debt factoring?

What is an example of debt factoring?

Photo credit: iStock/Ngampol Thongsai

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About the Author

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.

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