Debt billing is the term of a financial transaction in which a company sells its receivables to a specialized finance company. The receivables are sold at a discount and the finance company, known as the factor, is responsible for collecting the outstanding amounts. This is sometimes referred to as financing or factoring to accounts receivable.
This type of arrangement is used by companies to improve cash flow and shorten the cash cycle. The company is able to receive immediate cash from the factor and without carrying out the collection process. Before entering into a debt billing agreement, there are several 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 accounts receivable, the company receives cash immediately from the factor. This can be important if the business needs cash to pursue financial growth. It can also be an alternative for companies that are aware of taking on debt or issuing equity to raise capital.
Bad debt protection is a potential benefit. This only applies if the company has entered into a non-recourse factoring agreement. Under this type of agreement, the factor assumes the risk of bad debt. In other words, if a customer account cannot be collected, the factor must absorb the loss.
Cost-effective collections are another potential benefit. In selling its receivables, the company effectively hands over the entire collection of accounts receivable. While the cost of these processes is effectively built into the discount to which the receivables are sold, it can still be an attractive benefit for companies looking to save time or reduce the staff needed for back office work.
Before entering into a debt-to-business agreement, a business must also consider a number of disadvantages. The main disadvantage is cost. Under a factoring agreement, the factor purchases receivables at a discount. Depending on the discount amount, a factoring agreement can result in a very high cost of capital. These costs must be compared to the costs of other financing methods available to the company.
Another disadvantage is that when a company works with a factor, they introduce an outside influence into their business. Since the factor is responsible for collection of receivables and may be responsible for amounts that cannot be collected, they may try to influence sales practices. This can include trying to influence sales policies and timing as well as the customers a business is dealing with.
Bad debt obligations are a potential drawback. This would be relevant if the company has entered into a resource billing agreement. Under this type of agreement, the company is responsible for 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 relationships are one last potential drawback. Since a third party will now deal directly with customers to collect amounts owed, this may adversely affect the customer’s perception of the business. This is especially true if the factor is part of aggressive or unprofessional practices when collecting claims.
Debt factoring represents a complex business deal. It usually requires a long-term contract and modification of some sales processes. When assessing whether debt factoring is a good choice for a business, both the pros and cons must be weighed in order to make an informed decision.