Sources of Finance: Debt factoring
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Last updated 11 Aug 2019
Debt factoring is an external, short-term source of finance for a business. With debt factoring, a business can raise cash by selling their outstanding sales invoices (receivables) to a third party (a factoring company) at a discount.
Worked example of Debt Factoring
A business makes sales of £100,000 per month. Its customers are given 60 days to pay their invoices. On average, the business has around £200,000 owed by customers at any one time (receivables). The business needs to raise cash to improve its liquidity.
(1) Wait for customers to pay their invoices (e.g. 60 days)
(2) Sell these invoices to a factoring company for cash now (but at a discount)
With option (2):
The business gets up to 90% of their invoice value in cash now (£180,000)
The debt factoring company then collects the invoice payment from the customers and sends the remaining 10% of the value of the invoice to the business LESS a fee – typically around 3%. The business therefore receives around £14,000, costing them £6,000 in this example.
Benefits and Drawbacks of Debt Factoring
- Receivables (amounts owed by customers) are turned into cash quickly!
- Business can focus on selling rather than collecting debts
- The facility is practically limitless and therefore suits a fast-growing business.
- There is no security required – unlike a loan or overdraft.
- Quite a high cost – the charge made by the factoring company, typically around 3%
- Customers may feel their relationship with the business has changed