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The Definitive Guide to Debt Factoring

The Definitive Guide to Debt Factoring

Debt factoring is a term often heard in the business world without much explanation given to what it actually means. The following guide can help you to understand what it is, what is involved, how it affects the business and its customers, as well as also help you to understand if this is an action that is appropriate for your own business.

Understanding Debt Factoring

When a business has a significantly high accounts receivables balance it might consider selling its entire accounts receivable to another company, known as a factor, at a discounted amount that is based upon the prediction of how much money the factor can potentially collect from the open debt accounts. The company that has purchased the accounts receivable balances, or debt balances, then sets about collecting those open balances from the customers who are responsible for paying them.

From a customer standpoint, this is often seen when credit card balances, or even old telephone bills, are sold to another company who then will start the collection process. It can often prove to be very confusing to a customer who receives a statement on a balance owed from a company that they have never heard of. While the customer’s may prefer to pay the original company directly, once the debt has been sold to the factor, only the factor can accept the payment on the debt now as they are the ones who own it.

Parties Involved

There are three parties involved in debt factoring: the company who owns and then sells the receivable, the debtor (the customer who owes on the invoice), and the factor – the company who purchases the debt. When a business enters into a debt factoring agreement they are relinquishing all rights to collect on the open invoices. The factor takes on the right to collect on the debt while also taking on the risk that they customer might not actually make a payment on the open invoices – which means that the factor is taking on the potential to lose a significant amount of money in the event that they fail to collect.

The factor makes their business profit based upon the difference between the value of the accounts receivables and the amount that they actually paid the original company for it – assuming again that the debtors actually pay their debt. While taking into consideration any losses based upon non-payment, factors are often able to turn a good profit from those accounts that they are able to collect on.

Debt factoring should not be confused with invoice discounting; factoring a company’s debt means that the account receivables (open invoices) are actually sold to the factor (purchasing company). Invoice discounting, on the other hand, means that the company borrows cash from another business while using their accounts receivables as collateral for the loan.

How It Can Benefit A Company

If a business is having cash flow problems they may enter into a debt factoring agreement in an effort to raise their immediate available cash flow as they are able to get an infusion of immediate cash from the company that has purchased their accounts receivables debt based upon the predicted amount that they stand to collect from customers. Since the business no longer needs to wait for their customers to pay their bills before they are able to make good on their own debt or pay their staff it can prove to be a very positive move for a business.

However, business should keep in mind that since the accounts receivables are being sold to the factor at a discount they will still be taking a loss on their revenue stream. Businesses should carefully consider if taking out a business loan to cover their expenses while the debts are collected is perhaps a better course of action. A consultation with an expert business finance professional can help decision makers to make the best decision for the business.

Debt factoring can certainly prove to be beneficial to certain companies, dependent of course on their current financial situation, but it can also prove to be harmful to their relationships with their larger clients. Businesses should make every effort to collect on their accounts receivables before selling the debt to a third party – third party companies, due to the increased levels of financial risk that they have taken on, are very often a lot more aggressive with their collection tactics.

Photo courtesy of AMagill.

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