A Head To Head: Debt Collection vs Debt Factoring

As a company that is still in its first year of trading, we like to get ourselves about a bit, at various business functions and networking events. Some recent experiences at a couple of those events have inspired us to write this blog. We introduce ourselves at these events and then now and again someone will say, “oh ok, like debt factoring….”. Here is the rest of the story.

To start with let us say, although we have called it a head-to-head. It does not necessarily mean that debt collection and debt factoring are mutually exclusive. As you will learn when we delve into them below, it is more than possible for these two credit management functions to co-exist with, or even complement each other within the same company. So, there is our first challenge to the status quo, as they are often seen as options which can only exist exclusively of each other.

But still, we understand if you have got to this point in the blog, it is likely to be because you are interested in the differences in them, potentially as you are considering using one or the other for your own company. So, we will take a bit of a dive into both of them here and discuss the key features, and their advantages and disadvantages from a business point of view.

Let’s start with debt factoring, as it seems there is some uncertainty about what it is and how it works in practice when businesses decide to start using it to improve their cashflow situation. And that is probably a useful starting point, to clarify its purpose. The point of debt factoring to help businesses get the money that they are owed by their customers in the bank, more quickly.

The second point to make is that some of the confusion around what debt factoring is, is also understandable. We have had to do our own research on what exactly debt factoring is, to gain as full an understanding of it as possible for the purposes of writing this blog. So, we think it is no wonder, that others with less of an involvement in the sector get confused between debt collection and debt factoring. Hopefully things will be a bit clearer after this.

According to the Chartered Institute of Credit Management, debt factoring is a process by which your invoices are sold to a factoring company who will pay a certain percentage back to you for the value of the invoice (which they estimate to be usually about 80-85%) and then pay you the rest of the invoice, minus some charges, once your customer has settled the invoice. This means that you are getting 80-85% of your sales ledger settled as soon as it is invoiced.

Almost all the large companies that we have worked with in the past have not been able to collect 85% of their sales ledger on a month-by-month basis so from that perspective it sounds like there are some advantages. In addition to that the rest of the invoice will be paid once the customer settles the invoice with the debt factoring company so again it sounds like a good deal indeed.

What it is even better about it is the debt factoring company also take responsibility for doing the collection activities for the invoices that your company sends to them after they have paid out the initial 85%. For many companies this can represent a significant benefit since we have acknowledged on a few occasions in previous blogs just how challenging it can be to get the adequate resources (time, manpower, skill, and money) needed to do this for themselves.

But what about the disadvantages? Of course, there are some of those too. According to the CICM, the advance usually comes with recourse, which means if the customer does not pay the invoice, then the advance which was paid by the debt factoring company must be paid back. That suggests that debt factoring lends itself better to companies with a relatively low level of risk across their ledger but would still prefer to have the money a bit quicker.

The other disadvantage is that it comes with fees anyway. So regardless of whether or not the invoice is paid the company will have to pay a certain amount for the debt factoring service. Some rough estimates of the fees involved range from between 1.5% to 4%. This should be considered alongside the company’s profit margins as if they are very small then losing even a small amount of cash like this can create another pressure on the business.

So, what about debt collection? Well, there are lots of different ways of doing debt collection. So, all we can really talk about is our own approach. We have met a wide variety of different approaches over the years, and even within our own team people approach their accounts with different philosophies although we all work to the same goals at JSP Credit Management, which is the get more of our client’s money that is owed to them in their bank accounts as quickly as possible (notice the similarity to debt factoring there).

Debt collection does not involve sending the provider of a product or service money for their invoice as soon as it has been produced. Instead as debt collectors we tend to get involved once an invoice has already become overdue for payment. When that’s the case we agree to attempt to collect the debt on behalf of our clients and charge them a commission once the debt has been collected, which depends on how old and large the debt is.

The main difference there between this and debt factoring is if an invoice is paid on time, then it will never be subject to any fees because as debt collectors, we only become involved once a debt has already become overdue for payment. This means that companies that mostly have customers who pay them on time, and our market research tells us there are many of you, can enjoy 100% of the cash that they are owed for most of their sales ledger balance.

Another advantage is that we operate on a no-recovery, no-fee basis. So, in cases where our attempts to collect the debt outstanding have failed then there are absolutely no financial costs to pay for the client to us as their third-party debt collection agent. In contrast to debt factoring where an unsuccessful recovery prompts an obligation to repay the 80-85% that was advanced at the outset.

But there are disadvantages to using a debt collection agent too. At JSP Credit Management for example, our highest commission bracket is 25%. It is immediately obvious that this is quite a bit larger than the 1.5-4% in fees charges on average for a debt factoring service, and also using a debt collection agent does not help with customers who may pay just overdue each month but does not warrant enough of a delay to involve a debt collection agent, so debt factoring has a more beneficial impact on cashflow in that regard.

So, what is best? It is really difficult to say unfortunately. It very much depends on the individual circumstances of each company. It might be that certain aged debt profiles suit debt factoring more than debt collection services and vice versa. Hopefully however we have highlighted some of the factors worth considering when deciding which one would be more appropriate or if indeed there is a place for both in the business, by way of only factoring a portion of invoices out and relying on prompt payment on the others.

There is a great deal more to be considered when it comes to great credit management, but we hope we have given you a brief insight into some of the important and contemporary factors that need to be considered. If you are interested in knowing more or wish to have a chat about a particular area of uncertainty, then get in touch for a free no-obligation discussion contact us on 01827 66820 to discuss your needs.

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