Debt Factoring is a business finance solution that can help small and medium enterprises use their existing accounts receivable to secure an instant boost to their cash flow.
Debt Factoring, also known as Invoice Factoring, leverages outstanding invoices to unlock their value and allow businesses to access working capital.
An Introduction to Debt Factoring
At its most basic level, Debt Factoring works by having a business ‘sell’ its unpaid invoices to a factoring company and receive a percentage of the value of the invoices upfront.
The remaining balance is released to the business once the invoices have been paid by their customers, less any fees.
Debt Factoring is a popular financial solution due to its flexibility. It can help businesses generate the working capital they need to better manage cash flow and mitigate capital shortages.
How Does Debt Factoring Work?
Unlike traditional bank loans or overdraft facilities, this solution allows you to use your accounts receivable as collateral to secure immediate cash funding.
So, how does it work exactly?
When you send an invoice to the factoring company, such as ScotPac New Zealand, you can access to up to 95% of its value in working capital immediately.
Debt Factoring can be particularly useful for businesses that offer their customers extended payment terms. Standard business terms in New Zealand are around 30 days, but that assumes punctuality on the part of your customers. With debt factoring, you can release the capital tied up in unpaid invoices (overdue or otherwise) and quickly inject the cash you need into your business.
Is Debt Factoring the Same as Invoice Discounting?
While Debt Factoring and Invoice Discounting are very similar in the fact that they both enable you to access an upfront payment for your outstanding invoices, there are subtle but meaningful differences.
With debt factoring, you sell your unpaid invoices to the finance company, whereas with Invoice Discounting, the unpaid invoices are utilised as collateral more to secure a loan. In an Invoice Discounting facility, you use your accounts receivable to access a line of credit and repay the amount owed plus any fees once your invoices have been settled.
What difference does this make to you? It comes down to who is collecting the outstanding amounts from your customers.
With a factoring facility, the finance company providing you with the money is responsible for the collection of the invoice payment(s). Once you have raised the invoice, sent it to your customer, and submitted it to the factoring company, your job is done. The finance provider will be in charge of chasing payments and managing accounts receivable from there. For this reason, debt factoring is a preferred option for many smaller businesses that lack a robust accounts and collections departments.
On the other hand, with Invoice Discounting, you retain responsibility for your collections. When you raise an invoice and submit it to your finance provider, you are still expected to collect payment from your customer. This is why it is typically used by larger companies that have an internal collections department.
Advantages of Debt Factoring
Debt factoring offers businesses several benefits, especially if your company is looking to grow or you are a start-up struggling to meet the strict eligibility criteria that banks require for traditional loans.
Shorter Cash Cycles
Cash cycles are crucial for business growth. They can be delayed or disrupted by having to wait for customers to pay invoices. With Debt Factoring, you can access the working capital needed to invest in new inventory, negotiate supplier discounts, and secure new contracts with larger clients. By accelerating the cash cycle, your business will have quicker access to the capital needed to expand your business.
Reduced Overheads
By entering a debt factoring agreement, the finance company takes over the account management of your invoices and debt collections. This means you can eliminate the need to hire employees for customer payments and maintain an accounts receivable department.
According to HRM, the average cost of hiring a new employee has doubled in recent years to $23,860 per worker, not including the ongoing expense of a salary. Other sources indicate that new hires can cost up to 20% of their respective yearly salary. Either way, so this can represent a significant cost saving in reduced overheads.
More Accessible Finance
Debt Factoring is a much more accessible type of finance, compared to business loans, with more lenient eligibility criteria and more streamlined application processes. This can be particularly important for small start-ups and/or companies with a low credit rating.
With Debt Factoring, your line of credit is tied to the value of your accounts receivable. This means that as long as your business is making sales, you can always access credit when you need it.
Types of Debt Financing
Within the scope of Debt Financing, there are actually different types. It is important to understand the differences in the arrangement offerings as it can impact your liability for the factored invoices.
Recourse Factoring
Recourse factoring is a debt factoring arrangement where you remain responsible for the invoice amount even if your customer doesn’t pay the debt in full.
When entering into this agreement, the finance company commonly performs a financial check on your customers to assess their payment capability and reliability before agreeing to factor an invoice.
The advantage of this process is that it helps you avoid overextending credit to a customer who may be financially unstable. In other words, it protects you from bad debt.
The disadvantage is that if the customer fails to pay, you are liable for the outstanding amount. Due to the fact that recourse factoring minimises the risk for the finance company, it can often result in lower fees compared to non-recourse factoring arrangements.
Non-Recourse Factoring
Non-Recourse Factoring places all the risk of customers not settling invoices on the finance company. If your customer does not pay the invoice and the debt is uncollected, you do not have any liability or responsibility for the sum owed.
Understandably, as the finance company is taking on more debt, there is a larger factoring fee often required in the arrangement.
Please note that here at ScotPac New Zealand, we don’t currently offer Invoice Discounting without recourse.
Debt Factoring – an example
In this example, a business raises an invoice for $40,000.
If it offers extended payment terms to its customers, it could be waiting for over 30 days for the customer to pay the invoice. With Debt Factoring, the company can submit the invoice to the factoring company and receive 90% of its value upfront. This initial advance of $36,000 can be available within 24 hours of submitting the invoice, providing the business with immediate cash to pay suppliers, cover overheads, and start new orders.
When the customer ultimately pays the invoice, the finance company releases the remaining balance minus the agreed fees. With a 2% factoring fee, the finance company charges $800. So, of the remaining $4,000, you receive $3,200.
Overall, you receive $39,200 of the $40,000 invoice meaning that while your profits are slightly reduced, you gain sufficient working capital to pay suppliers and take on new orders, and make more in the long run.
In this way, Debt Factoring and Invoice Finance can be effective funding tools to accelerate business growth.
Debt Factoring with ScotPac New Zealand
Navigating the different types of Debt Factoring and determining which option is best for your business can be complex. At ScotPac, we understand that each business has unique financial needs, and finding the right solution is crucial for your growth and success.
If you’re unsure about which Debt Factoring option is right for you, or if you simply want expert advice tailored to your specific circumstances, our experienced consultants are here to help. We’ll work with you to understand your business goals and recommend the most suitable financing solution.
If you’d like to explore your options or have any questions, get in touch with a ScotPac lending specialist today.
