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Study notes

Sources of Finance: Debt factoring

  • Levels: A Level, IB, BTEC Level 3
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

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.

Debt factoring - an external, short-term source of finance for a business

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.

Options:

(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

Benefits

  • 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.

Drawbacks

  • Quite a high cost – the charge made by the factoring company, typically around 3%
  • Customers may feel their relationship with the business has changed

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