Advantages and Disadvantages of Using Debt Factoring

Advantages and Disadvantages of Using Debt Factoring

Advantages and disadvantages of using debt factoring must be considered before a decision is made on whether to use it or not. This is very important as doing this analysis will provide management with useful information for economic decision making. The advantages of using debt factoring must outweigh its disadvantages for its use to be economically viable.

What is Debt Factoring?

A debt factoring in financial management terms is the outsourcing of the credit control function of a company to a third-party.

Factors are normally owned by the banks (this is why they can afford to buy all non toxic debt that the opportunity presents itself). For an agreed fee, the factor takes on the responsibility of collecting debt on company’s’ behalf.

The services offered by factors can be:

• Debt collection and administration (Recourse and Non-recourse)- the factor takes over the sales ledger function of a business, issuing invoices and collecting debt.
• Financing- factor can advance up to 80% of the value of the debt to the company while they wait for the debtor to pay them back. The balance will be paid to the company net of finance cost up on collection of the balance. Interest rate usually between 1.5% to 3% above high street bank rate depending on location of your business and other risk factors.
• Credit Insurance- the factor will be willing to take up your irrecoverable debt but then decides who buys what on credit from your company.

Forms of Debt Factoring

Factoring with recourse:- this is where the business takes responsibility of any eventual default.

Factoring without recourse:- here, the responsibility of bad debt is on the factoring company. This form of debt factoring arrangement usually comes with some extra cost.

Advantages of using debt factoring

• Saving In Staff Time/ Admin Costs

One of the most prominent benefits of using a factoring company is that it saves the company the administration cost of having to update the sales ledger and incurring costs on chasing debtors.

• Frees Up Management Time

Management time that would have otherwise be used in managing and chasing debtors would be used in performing core duties that will add value to the company.

• Serves as Insurance

A business can enjoy some sorts of insurance in cases where it buys a non-recourse package from a factor. This will effectively mean that the business will not worry much about losing money due to bad debt- this comes at a cost though.

• Piggy Backing on Factors Facility

A company can for example use a factor’s credit control system to assess the credit worthiness of a prospective customer.

• New Source Of Finance

Factoring is traditionally designed to help businesses accelerate cash collection process by providing cash against outstanding receivables thereby improving cash flow and liquidity. This is a good way of raising finance quickly.

• Good For Small Businesses With Rising Sales

Very useful to small and fast growing business where the credit control department is still lean compared to the amount of work involved in doing all the required credit collection work in-house.

Disadvantages of using debt factoring

• Can be Expensive

The cost of borrowing (finance cost) is usually around 1.5% – 3% higher than the normal commercial bank lending rate. This coupled with other incidental costs of using a factor can be huge. Cost analysis activity is usually carried out to make sure that a company is not losing money by using a factor.

• Loss of Customer Goodwill

Some customer goodwill might be lost when a business starts using debt factor to collect money owed to them. This could be for various reasons ranging from the fact that most customers do not want their details to be passed to a factoring company –wrongly thinking that this will affect their credit rating. Customer may be reluctant to deal with a factor for fear of tarnishing their image- especially those that are looking to get mortgage loan from a bank.

• Difficult To Revert To Internal Credit Control System As Soon As a Company Starts Using a Factor

Reverting to normal in-house sales ledger and credit control function is not easy once the services of factoring company have been engaged. This could be due to management inertia or due to contractual agreement that might make the process of terminating the service of a factor lengthy.

• The Factor Decides Who Credit Is Given In Most Cases

The factoring company decides who gets credit when a non-recourse package is bought. This might be harming the company sales and growth as many potential customers are turned away simply because of inadequate previous credit history.

• May Send Wrong Signal That your Business Has Serious Liquidity Problem

People are wary of dealing with any company that uses debt Factor Company to manage its sales ledger. This is due to the impression that factoring companies are used by businesses that are struggling with cash flow.

Concluding

The use of factoring companies is encouraged as a working capital management technique but care must be taken in so doing. The advantages and disadvantages of using debt factoring that are discussed in this article should be given serious consideration before deciding on what to do.