Advantages and disadvantages of factoring for SMBs

Looking for extra capital to help your business to grow? Getting a bank loan is difficult, response times and fund disbursements can be lengthy, and the application process can be complicated.

Factoring provides an interesting and potentially exciting alternative option for small businesses. It lets you put unpaid customer invoices to work and receive extra cash up front, rather than waiting until payments come due. Which is a major advantage. 

But just as factoring has benefits, there are significant downsides to consider. We’ll explore both the pros and cons of this common lending process, and offer some equally helpful alternatives. 

Let’s start by defining this term, and seeing how it works. 

What is factoring?

Factoring lets companies assign their commercial receivables to a factor in exchange for an advance of funds. You hand over a selection of unpaid customer invoices to a third party, who gives you a cash advance on future revenue. The factor makes sure the invoices are paid in due course, at which point you settle the agreement. 

More fluid and faster than a bank loan, factoring doesn’t affect your company's debt ratio, as it immediately converts existing assets into cash.

The contracts are also typically simpler than those offered by banks. Banks can sometimes oppose a financing request, especially when the company is new or in a difficult financial situation.

The factor, on the other hand, bases its decision to accept or refuse a contract on the solvency of the clients. In other words, unlike a bank loan, a factoring contract can be granted even in case of cash flow difficulties.

How does factoring work?

Factoring is fairly simple in theory. But understanding how it works is essential in order to benefit fully. And in practice, it can quickly become more complicated than it seems on the surface. 

The factoring process

The factoring process can be summarized in five steps:

1. Your company issues invoices to clients, to be paid for goods or services delivered.
2. You assign receivables (those same invoices) to a third party—the factor.
3. The factor provides an advance of funds to the company, often ranging from 80% to 90% of the total invoice amount.
4. The factor handles the collection of the invoice payments from the client.
5. Once the invoice is paid, the factor pays you remaining balance, after deducting the fees associated with the factoring process.

The role of the factoring company

The third party plays two critical roles in this transaction: 

1. They provide capital to the borrower (you); and
2. They handle collections from your customers. 

Obviously the capital is what you’ve come to them for. But whether you actually want a third party dealing directly with your customers may be unclear. If your current collections process isn’t very efficient, it can be great to hand it off to someone else. But there’s also the potential for harm to your reputation if their work is indelicate. 

Factoring costs

Factoring involves fees that can vary depending on the quality of the receivables and the financial institution involved. Generally, these fees can be divided into three parts:

• Factoring commission, which ranges from 0.5% to 5% of the total invoice amount.
• Financing commission, similar to the interest rates you get from banks. The amount varies, and you should absolutely be clear about this before entering an agreement. 
• Administrative fees, which include dispute management fees or internet service connection costs. These also vary between providers, and you should understand them fully from the outset. 

While factoring services are fairly standard, the costs can vary significantly between providers. Always ensure you understand the likely costs involved before agreeing to a factoring arrangement. 

Advantages and disadvantages of factoring

As with any financial product, there are pros and cons to factoring. 

Advantages of factoring

The benefits of factoring include: 

• Cash up front. This is the obvious reason why most businesses work with factors. Unpaid invoices don’t bring you much value in the immediate term, unless you can turn these assets into cash.
  
  
• Working capital optimization. Factoring is a practical way to shorten your “days sales outstanding” and therefore your cash conversion cycle. The faster you bring cash into your accounts, the sooner you can use it to grow your business.
  
  
• More efficient collections. Factoring lets you outsource collections. If this is a process you struggle with today, that may be very appealing.
   
• No loss of equity. Factoring is a form of debt-based, non-dilutive financing. Unlike equity-based fundraising, which sees you hand over a portion of your company's ownership, factoring relies on your receivables. While you'll have to pay fees and interest right away, it's considered cheaper in the long term.

Disadvantages of factoring

The downsides of factoring include:

• High costs. Factoring is not generally considered a “cheap” financing option. While it is non-dilutive, you can expect to eat significantly into the profit margins associated with these invoices.
  
  
• Long wait times. While it’s often faster than securing a bank loan, factoring can still take longer than you’d like. There are lots of documents and solvency checks required, and the paperwork can be cumbersome.
  
  
• Inflexible arrangements. Some factors take an all-or-nothing approach—they want all of your unpaid invoices and don’t offer you the chance to select.
  
  
• Outdated processes. Factoring has been around a long time, and many providers still rely on paper and in-person meetings. Fast-moving, busy companies may find this too slow.
  
  
• A risk to customer relationships. Trusting a third party to deal directly with your customers may be a bridge too far for many small businesses. If you want to maintain healthy, long-lasting client relationships, this is real risk to be aware of.

Whether you see the glass as half full or half empty on factoring will depend on your particular circumstances and the offers you receive. For most SMBs, factoring is an option, but perhaps not the best.  

We have faster, more flexible financing available that’s designed to suit modern small businesses. ‍

More advantageous financing for SMBs

The biggest drawbacks to factoring come from a lack of flexibility, slow processes, and high fees. And previously you didn’t have much choice—factoring was the best option for SMBs that needed cash. 

But platforms like Defacto now offer near-instant, completely customized financing. You still raise funds against your receivables (or payables), but you choose exactly which invoices to include, and you keep control over your customer relationships. 

Compared with traditional factoring, Defacto offers several advantages and eliminates certain disadvantages:

• New financing agreements take on average 27 seconds to create.
• It’s entirely online, with no paperwork.
• We connect directly to your bank, invoicing and accounting tools and analyze your financing capacity accurately and fairly.
• Every agreement is personalized based on your data.
• You retain control over your cash receipts.
• Our financing process is smooth and pleasant.

In short, no factoring agreement can really compare. And getting started only requires a few clicks. 

See if you’re eligible for funding now.