Debt factoring: What it is and how it works

Published 5th March, 2023
Updated 10th May, 2023‍

What is debt factoring?

Debt factoring is an external, short-term form of financing where a business sells its outstanding invoices to a third-party factoring company.

Also known as invoice factoring, accounts receivable factoring, or AR factoring, this process helps to alleviate cash flow problems and avoid insolvency by giving the business access to money faster, instead of having to wait for customers to pay their invoices.

Table of contents

1. How does debt factoring work?
2. The advantages and disadvantages of debt factoring
3. How does debt factoring work?
4. Debt factoring vs accounts receivable financing 
5. Debt factoring vs B2B Buy Now, Pay Later
6. Proactive, flexible, online financing

How does debt factoring work?

Let’s say you offer your B2B customers purchases on invoice, (aka trade credit or net terms. While your B2B sales numbers look good, you’re still waiting to receive payment. Not having access to your entire working capital can prevent you from growing further and investing in your company. 

With debt factoring, you can sell those outstanding invoices to a factoring company and get paid right away instead of waiting until the end of the invoice term. The factoring company takes over the responsibility of collecting payment and provides you with a percentage of the total invoice value (usually between 80%-90%). 

Once your customer pays the invoice, the factoring company then returns the rest of the invoice value minus a small fee.

The cost of debt factoring can vary but it’s mainly based on two things - the processing fee and the service fee. The processing fee is usually between 1.5%-5% of the total invoice value. 

But the service fee (also known as the factoring period fee) will depend on the term length of the invoice. For example, it’ll cost you more to factor an invoice with 60 days left than 30 days. Typically, the service fee increases the longer it takes for the customer to pay the invoice.

As a simple example, take a look at the breakdown below based on a processing fee of 3% and a service fee of 1.5%.

In this example, it would cost you €450 to factor an invoice worth €10,000.

However, what happens if your customer pays late? Many debt factoring companies use a tiered structure and increase the service fee for every week the invoice is overdue. 

This means for every week over the due date your customer doesn’t pay, the cost of factoring increases.

In the new example below, the customer was 4 weeks late paying the invoice. The factoring company adds 1% per week the invoice is overdue, resulting in a higher cost of €850.

Is debt factoring right for your business?

As we’ve now seen, there are many advantages and disadvantages to debt factoring. Deciding whether debt factoring is right for your business will depend on several elements but broadly speaking, businesses that offer trade credit can benefit from it. However, you’ll need to decide if the disadvantages of debt factoring are worth it for you. For example:

1. Is it a financially viable option for you? As we’ve discussed, debt factoring reduces profits thanks to the cost involved. If you have many outstanding invoices and choose to access tied up working capital this way, those fees can quickly add up.

2. Are you prepared to take on short-term debt? If you offset the collection process for unpaid invoices to a factoring company, you’re essentially taking on a loan. While it’s true that you’re receiving cash up front for tied up capital, you owe the factoring company a fee for their services.

3. Are you happy that your customers will know? If your customers are aware that you’re using a factoring company, it could negatively impact your reputation. While invoice factoring frees up cash and allows you to be more agile, your customers may view this is a sign you need the money.

The advantages and disadvantages of debt factoring

Debt factoring advantages

Whether you run a startup business or a large multinational company, debt factoring can be used as a key element of your B2B strategy. Let’s take a look at some of these advantages in more detail:

Improved cash flow

The most immediate advantage of debt factoring is improved cash flow. By gaining access to the majority of your invoice value straight away, you no longer have to wait for the customer to pay. This means you can alleviate any cash flow issues you might have.

Gaining access to tied up capital can also help the growth of your company. Previously unavailable funds can now be used to support an expansion into a new market or the purchasing of business essentials.

Saves time and resources

Another advantage of debt factoring is that it can save your company time and resources. Managing invoices and ensuring your customers pay on time can be resource-intensive. 

If they don’t pay, you’ll find yourself chasing payments when you could be focusing on more productive things. On the other hand, debt factoring passes responsibility over to the factoring company. Which means no more chasing payments.

A quicker way to obtain financing

In some cases, businesses will apply for a loan to mitigate the cash flow problems caused by invoice terms. But this isn’t always a viable option, especially if you have limited collateral or a short financial history.

Factoring companies pay the most attention to the credit scores of the customer however, instead of the business. This makes debt factoring a faster alternative to financing when compared to bank loans.

Disadvantages of debt factoring

While debt factoring can offer some great fixes for your business, there are some drawbacks you should be aware of. Here are some of the potential disadvantages of debt factoring:

Reduces profit

Everything has a price and debt factoring is no different. While the factoring fee can vary from company to company, the cost of debt factoring can quickly mount up if the total value of your invoices is particularly high. In the example above, the cost of factoring a €10,000 invoice is €300.

If you factor multiple invoices, however, with a total value of €1,000,000, it’ll cost you €3000 (assuming a factoring fee of 3%). This can eat into your profit margin which ultimately leaves you with less earnings at the end of the quarter or year.

Short-term debt

Debt factoring gives businesses immediate working capital, but it also creates short-term debt. This debt should be repaid once the customer pays the invoice, but if there are payment issues, it can result in bad debt for you.

To avoid complications like this, it's essential to agree on who is responsible for an unpaid invoice before the factor lends the money. A basic credit check of customers can also help prevent payment problems in the future.

‍Lost control of sales ledger

‍When a debt factoring company takes over invoice payment collection, you give up some control over your sales ledger and sacrifice some confidentiality. Customers are usually credit checked, and they'll know that the service has been outsourced, which could impact customer relations.

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Debt factoring vs accounts receivable financing

Despite sometimes being used interchangeably, there are some distinctions between debt factoring and accounts receivable financing.

With accounts receivable financing, a lender advances you a percentage of the value of your receivables - as much as 90%. Once your customer pays their invoice, you receive the remaining balance minus a lender’s fee.

Lender’s fees can vary depending on the financing company but generally they’re between 1-5%. Bear in mind though, that the amount you pay in fees is based on how long it takes your customer to pay their invoice. The longer they take, the more expensive it is for you.

Read more about accounts receivable financing.

Debt factoring vs B2B Buy Now, Pay Later

The demand for flexible B2B payments has been the driving force behind advances in embedded finance and automated payment reconciliation. With that, comes the application of B2B buy now, pay later, offering a simpler way of offering your business customers net terms with some considerable benefits including:

• Increased conversions rates, B2B sales, and average order value
• Drastically reduced admin time
• Offsetted credit and fraud risk
• Improved cash flow

When you consider that 1 in 5 corporate insolvencies are due to late payments, B2B buy now, pay later can solve many issues these businesses face. Getting paid upfront, for example, eliminates the need for debt factoring as businesses receive payment for their trade credit sales at the point of sale.

When compared to debt factoring, B2B buy now, pay later is also far more streamlined and cheaper.

Some players in this space are strictly finance providers, whereas others are full-scale B2B payment suites (like Two!) that take care of everything from credit checking and customer verification, to payment reconciliation and invoice management.

So what are some of the key differences between BNPL B2B and debt factoring?

Proactive, flexible, online financing

Traditional debt factoring can be time-consuming and reactive, making it difficult for businesses to access their working capital. Selling on net terms means waiting for payment, which can hurt growth and requires companies to take on credit and default risks.

B2B Buy Now Pay Later offers a solution by paying businesses upfront for their invoices. The seller doesn't have to collect payment because integrated financial partners handle it through the B2B BNPL platform.

With traditional debt factoring, there can also be discrepancies between the credit risk established by the seller and what invoices the lender is willing to buy. For example, a seller may offer trade credit after running credit checks, but the lender may still deem the risk too high to finance.

B2B BNPL solves this issue by making the credit decision at the checkout instead of after the sale. Additionally, dynamic credit limits based on the customer's risk profile make B2B BNPL a superior option. Merchants can access credit limits in real-time thanks to advanced credit engines built into the B2B BNPL platforms, creating a streamlined invoice financing option.

Two - The complete B2B payment suite

Two’s payment technology enables businesses across all industries to offer purchasing on invoice, providing a frictionless checkout experience with instantly approved credit. Our revolutionary B2B solutions simplify the payment journey so businesses can access working capital and increase B2B sales while reducing time consuming operational work.

Selling B2B with Buy Now, Pay Later can be incredibly complex. But it doesn’t have to be. With Two’s B2B payment suite, you can increase conversion rates and average order value while eliminating admin and offsetting credit risk.

Whether you want to supercharge your B2B e-commerce checkout, optimise your trade account for frictionless customer onboarding, or offer B2B BNPL on all sales channels - Two is here to help.