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Understanding Debt Factoring for Small Businesses

What is Debt Factoring for Small Businesses?
Lauren Ward
Lauren WardUpdated July 16, 2023
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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

About the Author

Lauren Ward

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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