Pros and Cons of Debt Factoring Arrangements
Debt factoring is the term for a financial transaction in which a business sells its accounts receivable to a specialized finance company. The receivables are sold at a discount and finance company, known as the factor, has the responsibility of collecting the noticeable amounts. This is sometimes referred to as accounts receivable financing or factoring.
This kind of arrangement is used by businesses to enhance cash flow and shorten the cash cycle. The business is able to receive immediate cash from the factor and without carrying out the collections course of action. Before entering into a debt factoring agreement, there are several pros and cons to consider.
The dominant assistance of debt factoring is that it provides a quick method of financing. Instead of waiting to receive cash from customer accounts receivables, the business receives cash closest from the factor. This can be important if the business needs cash to pursue finance growth. It can also be an different for businesses cautious of taking on debt or issuing equity to raise capital.
Protection from bad debts is a possible assistance. This would only apply if the business has entered into a non-recourse factoring agreement. Under this kind of agreement, the factor assumes the risk of bad debts. In other words, if a customer account cannot be collected, the factor must absorb the loss.
Cost effective collections is another possible assistance. In selling its accounts receivable, the business is effectively handing off the complete course of action of accounts receivable collections. While the costs of this processes are effectively built into the discount for which the receivables are sold, it can nevertheless be an attractive assistance for companies looking to save time or reduce employees needed for back office work.
Before entering into a debt factoring agreement, a business must also consider a number of disadvantages. The dominant disadvantage is cost. Under a factoring agreement, the factor purchases accounts receivable at a discount. Depending on the discount amount, a factoring agreement may imply a very high cost of capital. This cost must be compared to the cost of other methods of financing obtainable to the business.
A second disadvantage is that when a business works with a factor, they are introducing an outside influence into their business. Since the factor will be responsible for collecting accounts receivable and may be responsible for amounts which cannot be collected, they may try to influence sales practices. This can include attempts to influence sales policies and timing, in addition as the customers that a business with deal with.
Bad debt limitations are a possible disadvantage. This would be applicable if the business has entered into a resource factoring agreement. Under this kind of arrangement, the business is responsible for any amounts that cannot be collected from customers. The discount rate at which the factor purchases the accounts is usually lower, but this must be considered in light of possible charges for uncollectible accounts.
Customer relations are a final possible disadvantage. Since a third party will now deal directly with customers to collect amounts owed, this can have a negative impact customer perception of the business. This is especially true if the factor engages in aggressive or unprofessional practices when collecting receivables.
Debt factoring represents a complicate business agreement. It usually requires a long term contract and the alteration of some sales processes. When evaluating whether debt factoring is a good choice for a business, both pros and cons must be weighed to make an informed decision.