What are the Disadvantages of Factoring?

Factoring is a financial service that allows businesses to sell their invoices, or accounts receivable to a third party, known as a factor, in exchange for immediate cash, which can be used to continue operations.

This service has become standard practice throughout the years because of its ability to improve cash flow, provide more accessible financing, and reduce administrative burden.

However, there are several disadvantages to factoring including the fact that factoring is essentially the practice of maintaining cash flows by paying fees to a third party. This process essentially reduces profits.

What is Factoring?

Factoring is a process by which a business sells its accounts receivable to a third party for immediate cash. The factor takes on the responsibility of collecting payments on the invoices, allowing the business to focus on other aspects of its operations. Factoring is a direct result of businesses not paying as they go.

The Disadvantages of Factoring

Factoring has become standard practice in the freight industry because it helps provide immediate cash flow, instead of waiting for invoices to be paid. Freight companies often have to wait weeks or even months to get paid for their services, which can create a cash flow problem.

Factoring allows a business to get immediate cash for their accounts receivable, which they can use to pay for expenses, such as fuel, maintenance, and payroll.

However, despite its short-term benefits, factoring comes along with a variety of disadvantages and risks that could potentially hurt shippers, carriers, and brokers in the long run.

Fees

The biggest disadvantage of factoring is the cost, as factors don’t provide this service for free. Instead, a business must pay a fee which is usually a percentage of the value of the invoices being factored. Most factoring companies require all invoices to be factored, not just a chosen few invoices.

The fee can vary depending on several variables, including a customer's credit history, the number of invoices being factored, and the amount of time it will take for the invoices to be paid. These fees usually are a direct reduction of profits as they are not anticipated in the pricing process.

Factoring does not remove the risk of getting paid. Factoring companies are not responsible for invoices that are not paid on time.

Factoring companies will also charge a fee on invoices, run through them, that are paid immediately.

Long-Term Impact on Cash Flow

The main reason that factoring has become so prominent in the logistics and freight industries is that it provides immediate cash flow to businesses. However, this could potentially have a negative impact on the business's cash flow in the long term. Factoring directly reduces profits as the fees are not normally considered as part of the original price structure.

Because factors charge a fee for their services, the business is essentially selling its accounts receivable at a discount, cutting into the long-term profits of the business.

Risk of Unpaid Invoices

Some failed collection processes result in a charge back of the invoice to the original business as the risk for non payment is not accepted by the factoring company.

Effect on Customer Relationships

When a business sells its invoices to a factor, it gives control of the collection process to the factor, which then takes over the responsibility for collecting payment on the invoices. While this in and of itself may initially seem like a benefit, it could also have potentially harmful consequences when maintaining a good relationship with your customers.

Once this responsibility has been turned over to the factor, it will be in their best interest to do whatever they can to receive payment for the invoice. The debt collection practices of some factoring companies may be aggressive and could potentially harm your customer relationships.

Factoring companies require assignment of all invoices to be factored. This reduces the profits even further as each invoice now must be factored. Businesses cannot pick and choose invoices to be factored.

Effect on Business Decisions

When businesses sign a contract with a factoring company, they generally turn over final say on what loads can and cannot be hauled over to the factoring company. If the factoring company does not like the details of the load, the carrier is obligated to find a different option.