Debt factoring takes place when a business sells its accounts receivable to a specialized finance company known as a factor. The receivables are sold at a discount and the factor has the responsibility of collecting the outstanding amounts. This is also referred to as accounts receivable financing or factoring.

This type of arrangement is used by many businesses to improve cash flow and shorten the cash cycle. The business receives immediate cash from the factor and does not have to handle the collections process. Before entering into a debt factoring agreement, there are several key advantages and disadvantages to consider.

The primary benefit of debt factoring is that it provides a quick method of financing. Instead of waiting to receive cash from customer accounts receivables, the factor pays the business immediately. This can be important if the business needs cash to pursue future growth or expansion. It can also be a viable alternative for business wary of taking on debt or issuing equity to raise capital.

Another key benefit is that cash flow is improved and the cash cycle is shortened. The amount of time it takes a business to turn cash to goods to cash is accelerated. This fast turnaround may allow the business to take on additional customers or purchase additional inventory.

Protection from bad debts is a potential benefit. This would only apply if the business has entered into a non-recourse factoring agreement. Under this type 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 potential benefit. The business does sell the accounts receivable at a discount, but it also hands off the entire process of accounts receivable collections. The business has effectively outsourced the process which can save valuable time or reduce the number of employees needed for back office work.

On the other side of the equation, debt factoring does carry a number of distinct disadvantages. The primary disadvantage is the cost. Under a factoring agreement, the factor purchases accounts receivable at a discount. Depending on the discount percentage, a factoring agreement may imply a higher cost of capital. This cost must be compared to the cost of other methods of financing which are available 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, as well as the customers that a business with deal with.

Bad debt liabilities are a potential disadvantage. This would be applicable if the business has entered into a resource factoring agreement. Under this type 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 potential charges for uncollectible accounts.

Customer relations are a final potential disadvantage. Since a third party will now deal directly with customers to collect amounts owed, this can negatively impact their perception of the business. This is especially true if the factor engages in aggressive or unprofessional practices when collecting accounts.

Debt factoring represents a complex business agreement. It usually requires a long term contract and the modification of some current sales practices. When evaluating whether debt factoring is a good choice for a business, both advantages and disadvantages must be weighed to make an informed descision.