Sources of Finance – Debt Factoring

The use of debt factoring as a short-term source of finance is explained in this short revision video.

Hi there let’s take a look at one of the sources of finance available to most businesses this one is called factoring don’t forget for businesses there are a variety of sources of finance available ranging from long term such as share capital retain profits all the way through to the short-term capital business needs to help it trade day-to-day this is where

Factoring comes in factoring is a short-term source of finance but what is it well factoring raises finance for a business because the business sells an asset for cash and the asset concerned is the the trade receivables the sales invoices that are owed to the business by its customers how does it raise cash well it sells those invoices to a third-party finance

Company called a factoring company who buy those sales invoices in return for cash now let’s just look at a simple example to illustrate how this works in this case a business makes sales of a hundred thousand pounds per month on credit and it gives its customers 60 days on average to pay their invoices on average the business therefore has around about 200 000

Pounds owed to it by customers at any one time so-called trade receivables 200 000 pounds but the business needs to raise cash to improve its liquidity well clearly it’s got two options hasn’t it one option is to wait until those customers pay their invoices and we’re told on average it’s 60 days so on average each month you might get a hundred thousand pounds which

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Is the sales you made two months ago a second option though is factoring we could take some or all of those invoices that are owed to us and sell them to a factoring company who will pay us cash well here’s how it works and here’s why you can see why the factoring company may wish to get involved in this let’s say we decide to sell all of our trade receivables

200 000 pounds to the factoring company because we need the cash now rather than waiting for it we would get let’s say 90 percent of those invoices paid to us by the factoring company in cash so we get 90 of 200 000 pounds we’re getting cash 180 000 pounds but that’s cash now rather than cash in 60 days time the factoring company buys the right to recover those

Invoices they become their debts and they would hope to collect all if not nearly all the two hundred thousand pounds they bought and you can see there for the factoring company in this simple example would hopefully make a profit of twenty thousand pounds if it managed to collect all those debts that’s the two hundred thousand pounds it collects less the hundred

And eighty pounds that’s given to the business well you can see from that simple example that there are some benefits as well as potential drawbacks of factoring to a business the most important benefit being that you can turn trade receivables into cash quickly which obviously helps liquidity and also you can focus on the business activities rather than spending

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Too long trying to collect debts big drawback of factoring is that there is often quite a high cost associated with it the factoring company will look at the risks of the debts and they will offer a discount to the invoice value in order to give them the profit margin to make it worthwhile collecting the debts and there’s also a potential risk that customers of

The business may feel as though their relationship has changed a little because they’re now dealing with the factoring company rather than the business when it comes to paying their debts but there we go there’s a a quick overview of factoring as a source of finance you

Transcribed from video
Sources of Finance – Debt Factoring By tutor2u