When your business is in a pinch, and you need a way to pay back what you owe and still have enough cash in the bank to operate, invoice factoring usually comes up sooner or later. Can factoring help your business pay down existing debt? The short answer is yes in some cases, and no in many others. Invoice factoring can help pay down debt because it helps with cash flow. And the more cash flow you have, the more you can put toward existing debt. But it comes with a price, literally.
It Isn’t a Loan
Invoice factoring sounds a lot like taking out a loan, but it isn’t a loan. The business transfers or sells the receivables to a factoring company and receives cash for its assets, minus an agreed upon discount or fee. A factoring company purchases the receivables from a company and is responsible for collecting the money from the business’ customers and clients. You’re selling an asset, a valuable asset. When you factor your invoices, you’re selling them at a discount. There is no interest rate to pay. Since no loan is involved, there is no debt to pay back. The drawback is you pay the discount fee.
The factor rate is the discount rate you sell your invoices at. It decides how much cash you get: sell $100,000 of invoices at a factor rate of 5% and you’d receive $95,000.
It’s up to you whether or not to tell your customer that you’ve sold the invoice to a factoring company. They’ll get a notification of assignment anyway from the factoring company. If you don’t want them to be surprised by this, it might be better to tell them ahead of time that someone else will be collecting payment. Remember, you’re not just selling your product; you’re selling a relationship.
Here’s how it works.
- First, you invoice the customer you want to get paid for.
- Second, you and the factoring company agree to the terms: the “factor rate” (a percentage of the invoice that is your cost for the service), any additional fees, and the percentage that the factor will withhold to reserve against potential collection problems.
- Third, you sign over the legal right to collect to the factor, kind of like signing the back of a check so someone else can cash it.
- Fourth, the customer pays the factoring company.
- Fifth, if anything was withheld in step 2, the factor pays you what is still due.
When Does Factoring Make Sense
Factoring can be a great way to pay off a loan, as long as the interest rate on the loan is higher than the cost of factoring the invoices used to pay it. If you take out a one-year loan for $100,000 at 10% interest, you’ll pay about $10,000 in interest, for a total of $110,000. But factoring $110,000 of invoices at a 5% factor rate will cost $5,500, and you’ll net $104,500. In this case, factoring is cheaper. But don’t forget to check for curtailment penalties, because sometimes those wipe out the potential savings from factoring. You want to make sure factoring isn’t harming your business. At least not more than it’s helping it.
Qualifying works differently, too, because the factoring company is buying the right to collect the receivables from your customers. That is why it looks at your customer’s business credit score and financial history. If the company’s financial statements don’t show strong cash flow or a decent business credit score, the factor may reject the invoice because it doesn’t feel confident that it will be able to collect.
So when does factoring make sense? When you have sales but your credit score or lack of collateral makes you ineligible for a regular small business loan, you can turn to factoring. Another reason for factoring is if you have no time to wait for a typical bank loan’s approval process, which can drag on for weeks. Factoring can get you the cash you need fast. And, as shown above, it can make sense when your loan costs more than the factor rate.
Inherent Risk
But it’s important to note that there is an inherent risk in the financial instrument itself that gets often glossed over: recourse. With recourse factoring, your customer pays the factor, and you get a paycheck for the work you did. If they don’t pay, you’re on the hook for the invoice amount. If you’re overextended in debt, this is a potentially serious risk. If you don’t have the cash flow to pay a factoring company and your customers won’t pay you, factoring is just too risky. You can opt for a non-recourse contract, where the factor can’t hold you responsible if the customer doesn’t pay for your goods. Non-recourse financing is an option with lower risk for you, but factor rates are also higher. Even with a customer you trust, timing matters. If the customer’s industry is in a temporary downturn of one to two years, a small business loan is a better solution.
Factoring probably doesn’t make sense if you don’t really need the cash. If you have plenty of cash on hand and future cash flow is relatively stable, it might not be necessary to “sell” your accounts receivable for something less than face value. For example, if you’re buying a $50,000 piece of equipment and have $100,000 in the bank, there’s no real need to give up 5% or more of one of your invoices. Additionally, if your relationship with your customer is already strained, using factoring might make it worse. Once you assign a bill to the factor, you have no control over the collection process. They could start pestering or bullying your customer, and that relationship is yours to lose.
So, does factoring help you pay down debt? Yes, factoring can help you pay down debt when your customers are solid, you need cash fast, and the factor rate is lower than what your loan is costing you. If those things aren’t true, it can leave you worse off. You can try to negotiate with your creditors, but it’s not a sure thing. Either way, run the numbers before you sign anything.
