A Perfect Scenario to Explain How Debt Factoring Works

Whether you call it debt factoring, invoice factoring, or even invoice finance, the practice of selling invoices to a factoring company to raise quick cash has been utilized by business owners for centuries. It remains a popular financing option because it just works. If you are not sure how debt factoring works, this post should answer most of your questions.

The basic premise is pretty simple. A company needing to raise cash sells an invoice to a factoring company. The factoring company pays the business a certain percentage of the invoice’s value upfront. The remainder is forwarded to the business when the invoice is paid, less the factoring company’s fee.

To make this easy to understand, we have created a fictional scenario involving a company that has to spend money on order fulfillment long before the customer is actually billed. The scenario is pretty common in our industry.

Selling Merchandise to a Customer

Imagine a small business with several years of history behind it. It is a growing company on the verge of significant expansion. They get an order from a new customer, an order with a price tag higher than anything they have done in the past. Invoice terms on the order will be 30 days from the date of shipment.

The company has to tap into its own cash to produce the products for this order. That cash will be tied up through the entire production period and the 30-day invoice term. That’s the bare minimum. But if the customer happens to be a slow payer, the company could be waiting as long as 45 days after invoicing. In either case, they do not have access to the spent cash. It is tied up in the order they just shipped out.

They Sell the Invoice

Company management wants to put the cash back into their business. They need it sooner rather than later. So they decide to sell their invoice to a factoring provider.  The factoring provider agrees to give them a certain percentage of the invoice upfront. As soon as the company’s application is approved, the factoring provider forwards the initial payment. The company goes on its way and keeps its business going.

Their customer ends up paying its bill three weeks later. The factoring provider forwards the remaining invoice balance, minus their fee which was agreed to by both parties in the original contract.  The company has settled its invoice, the factoring partner has earned its fee, and the original customer has the products it wants. Everybody ends up a winner.

Debt Factoring Preserves Cash

The point of this fictional example is to illustrate how debt factoring works to help a company can fill expensive orders without jeopardizing cash flow. For companies on the verge of major expansion, debt factoring can act as a lifeline during that difficult transition from smaller company to bigger company.

A growing company cannot always afford to tie up significant amounts of cash to fill new orders. It needs cash to continue buying raw materials. It needs cash to pay its own bills.  At some point down the road, when even the largest invoice is but a drop in the proverbial bucket, waiting 30-45 days to get paid will not put such a crunch on a company’s cash flow. But for now, tying up a lot of cash in a single invoice isn’t doable.

Debt factoring gives a company access to cash by leveraging the value of outstanding invoices. It is a proven strategy companies have been using for a long time. It might be something that could help your company.