Factoring – also known as 'debt factoring' – involves selling your invoices to a third party. In return they will process the invoices and allow you to draw funds against the money owed to your business. Essentially, these companies provide a finance, debt collection and ledger management service. It is commonly used by businesses to improve cash flow but can also be used to reduce administration overheads. Businesses that supply this service are called factors or debt factoring companies. Invoice discounting is an alternative way of drawing money against your invoices. However, your business retains control over the administration of your sales ledger. As well as providing finance, it offers valuable support services and credit insurance.
Factoring and invoice discounting are collectively known as ‘invoice finance’ but are often just referred to as ‘factoring’, though they are distinct products. These guides provide information on how factoring and invoice discounting work, the advantages and disadvantages, different types of factoring and invoice discounting, the cost, and how to choose a factor or discounter
How factoring works
Factoring provides a fast prepayment against your sales ledger. It allows you, at a cost, to flexibly increase your working capital and improve cash flow by effectively selling your unpaid invoices to a factoring company. Factoring is offered to businesses trading with other businesses on credit terms. It is not normally available to retailers or to cash traders.
When factoring starts
Factors can be independent, or subsidiaries of major banks and financial institutions. Whatever their background, they will want to meet you, visit your business, review your financial situation and study your business plan to evaluate your suitability for a factoring facility. Credit limits on your customers might be required in order to limit the amount of invoices that need factoring – if so, you must agree how they will operate.
After signing an agreement, the factor will typically agree to an immediate advance of up to 85% of approved invoices – with the balance to be paid when the debtor pays the debt. The initial payment is usually made available within 24 hours. Usually all sales go through the factor. Check the notice period to the end of the service – most factors require three months’ notice, but some require longer. Negotiate if you are not happy with the notice period.Factoring is more complex than some other forms of funding. And you may wish to take professional advice before using factoring for the first time.
When an invoice is raised
You raise an invoice, which has instructions to pay the factor directly, and send it to the customer. Send a copy of the invoice to the factor.The factor makes available an agreed percentage of the invoice for you to draw as you require. The factor issues statements to the customer on your behalf. It operates credit control procedures including telephoning the customer if necessary. You will agree the protocol for contacting the customer with the factor beforehand.
When an invoice is paid by the customer
The customer should pay 100% of the invoice directly to the factor. The factor pays the balance of the invoice to you.
When an invoice is not paid
If an invoice is not paid, responsibility for paying the debt will depend on the type of agreement – either recourse factoring or non-recourse factoring. In recourse factoring you are liable for the debt, in non-recourse factoring the factor takes on any bad debts.
There are generally two main elements to the cost of a factoring arrangement. An agreed factoring fee is taken when the invoice is received by the factor. There will also be a ‘discount charge’ which works like interest and is calculated against the balance of funds drawn and usually applied on a monthly basis.
Advantages and disadvantages of factoring
There are numerous advantages to factoring, but also some potential drawbacks, as with any type of funding.
Factoring provides a large and quick boost to cash flow. This may be very valuable for businesses short of working capital. A business owed £500,000 may be able to get £400,000 or more in just a few days.
· there are many factoring companies, so prices are usually competitive
· it can be a cost-effective way of outsourcing your sales ledger while freeing up your time to manage the business
· it assists smoother cash flow and financial planning
· some customers may respect factors and pay more quickly
· factors may give you useful information about the credit standing of your customers and they can help you to negotiate better terms with your suppliers
· factors can prove an excellent strategic - as well as financial - resource when planning business growth
· you will be protected from bad debts if you choose non-recourse factoring
· cash is released as soon as orders are invoiced and is available for capital investment and funding of your next orders
· factors will credit check your customers and can help your business trade with better quality customers and improved debtor spread
Queries and disputes may have to be referred on and may have a negative impact on your available funding. For this reason, factoring works best when a business is efficient and there are few disputes and queries.
The cost will mean a reduction in your profit margin on each order or service fulfilment. It may reduce the scope for other borrowing – book debts will not be available as security. Factors will restrict funding against poor quality debtors or poor debtor spread, so you will need to manage these funding fluctuations. To end an arrangement with a factor you will have to pay off any money they have advanced you on invoices if the customer has not paid them yet. This may require some business planning. Some customers may prefer to deal directly with you.
How the factor deals with your customers will affect what your customers think of you. Make sure you use a reputable company that will not damage your reputation.
What makes a business suitable for factoring?
Factors’ requirements vary, so what follows are an indication and not a rigid list. You may find a factor even if the following criteria are not met.
What makes a business suitable for factoring?
Your business may be suitable for factoring and will benefit most if it has:
· an annual turnover of at least £50,000, although some factors will consider start-ups and smaller businesses
· a good spread of customers – there may be funding restrictions ifa single customer accounts for more than about a third of turnover
· simple, non-contractual debt that is easily proven
· low levels of debt more than 90 days overdue
What makes a business unsuitable for factoring?
Your business may not be suitable for factoring if it:
· sells to the public – factoring is only available for sales to commercial customershas too many small invoices
· has too many disputes and queries
· is not a sound, reputable and trustworthy business
· has customers that make part payments or stage payments
· has complex contractual arrangement or warranty provisions
Recourse factoring and non-recourse factoring
In recourse factoring, the factor does not take on the risk ofbad debts. Put another way, the
factor will be able to reclaim their money from you if the customer does not pay. The factoring agreement will specify how many days after the due date for payment you must refund the advance.
Whether you refund the advance or not, you will still have to pay the fee and interest (discount charge). Recourse factoring is cheaper than non-recourse factoring and may have fewer requirements concerning your customers and your systems. This is because you are taking the bad debt risk.
· The factoring agreement requires payment to be made within no more than three months. It also states that 80% of each invoice will be advanced.
· On 30 April an invoice for £10,000 is issued and the factor advances £8,000.
· On 31 July, if the customer has not paid, £8,000 must be repaid to the factor. There is no refund of the factoring fees relating to the debt.
In non-recourse factoring, the factor takes on the bad debt risk. It accepts specified risks around the debtor’s failure to pay, but it does not insure against debts that are unpaid because of genuine disputes. Because of this, non-recourse factoring will be more expensive than recourse factoring.
You never have to refund the advance to the factor, but you must pay the discount charge (interest) to the factor for any advance against the invoice for the period prior to the bad debt payment being made. The factor takes over all rights to pursue the customer for payment. This includes the right to take legal action.