Factoring and invoice discounting: the basics

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 cashflow 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.

This guide gives 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.

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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 cashflow 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. You can find an invoice financing presentation on the Asset Based Finance Association (ABFA) website- Opens in a new window.

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 per cent 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 per cent 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. See the page in this guide on recourse factoring and non-recourse factoring.

Charges

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. See the page in this guide on the cost of factoring and invoice discounting.

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Advantages and disadvantages of factoring

There are numerous advantages to factoring, but also some potential drawbacks, as with any type of funding.

Advantages

Factoring provides a large and quick boost to cashflow. This may be very valuable for businesses that are short of working capital. A business that is owed £500,000 may be able to get £400,000 or more in just a few days.

Other advantages:

• 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 cashflow 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 – see the page in this guide on recourse factoring and 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

Disadvantages

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.

Other disadvantages:

• 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.

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What makes a business suitable for factoring?

Factors’ requirements vary, so what follows is 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 if  a 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 customers
• has 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

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Recourse factoring and non-recourse factoring

 recourse factoring, the factor does not take on the risk of bad 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). See the page in this guide on the cost of factoring and invoice discounting.

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. For example:

• The factoring agreement requires payment to be made within no more than three months. It also states that 80 per cent 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.

Non-recourse factoring

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.

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Invoice discounting

Invoice discounting is an alternative way of drawing money against your invoices that allows you to retain control over your sales ledger. It can provide a cost-effective way to improve your cashflow.

Invoice discounting is only available to businesses that sell products or services on credit to other businesses and isn’t normally available to retailers or cash traders. It is normally only available to businesses with a proven track record and an annual turnover of at least £500,000.

However, it may not necessarily be the cheapest form of finance available and can tie you into a long contract.

How it works

Invoice discounting provides a fast prepayment against your sales ledger. It allows you, at a cost, to flexibly increase your working capital and improve cashflow.

The invoice discounter will want to visit your business, review your finances and study your business plan to evaluate your suitability for invoice discounting. They will also regularly check that your business procedures are effective.

You will pay a fee to the invoice discounter, usually a percentage of the value of the invoices or an agreed fixed fee and discount (interest) on the net amount advanced. They will be notified of the invoice details electronically – through downloads of sales day books or invoice listings.

Once they receive notification, the invoice discounter will make funds available at the agreed percentage rate, which you can then use as required. As cash is received from debtors, it is paid to the invoice discounter, reducing the outstanding balance and making the remaining amount available.

Further invoice notifications will generate further availability – so your account balance will fluctuate as invoices are assigned, funds are drawn and cash is received. The invoice discounter will recalculate the amount available to you after every transaction.

Find an online presentation on invoice financing on the Asset Based Finance Association (ABFA) website – Opens in a new window.

You’re not required to inform your customers you are using invoice discounting, as you still collect the debts and do the credit control – see our guide on ensuring customers pay you on time.

You can choose between recourse and non-recourse facilities, determining who is responsible for recouping unpaid invoices. See the page in this guide on recourse factoring and non-recourse factoring.

Selective Invoice Discounting

Selective Invoice Discounting is only offered by a few financial providers, and allows you to choose individual invoices or customers/debtors for discounting and so receive funding on an invoice-by-invoice basis. This flexibility is ideal for smaller businesses – especially if you deal with large single orders, single customers or have seasonal trading patterns.

Fees for Selective Invoice Discounting are higher, but it can be more cost-effective as you won’t need to process all invoices through the facility. You may have to pay an account set-up fee and there is often a minimum invoice value.

There are a number of benefits of using Selective Invoice Discounting, including:

• greater flexibility – you don’t have to notify the invoice discounter of all sales invoices and you only pay fees for invoices you use
• quick funding – the simple process often allows providers to complete within days
• open contracts without long term ties
• no leaving fees for ending an agreement
• as with invoice discounting, you still manage debtors’ accounts and can maintain business relationships – but you can ask a provider to help with credit management

You should not enter into any Selective Invoice Discounting agreement if you are in dispute or facing queries from a customer or debtor. You should be aware of the costs associated with any agreement as these can be expensive and could affect your profit margin.

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The cost of factoring and invoice discounting

The costs of factoring and invoice discounting can change depending on the company offering the service, and are often negotiable. It is a good idea to consider several suppliers, and compare the:

• discount charges (interest) offered
• service or management fees
• any additional costs – eg for additional services such as credit protection
• notice period for ending the service – most providers require three months’ notice, but some have notice periods of up to a year which could be expensive for your business

Discount charges

Discount charges work in exactly the same way as bank interest.

Typical charges range from 1.5 per cent over base rate to 3 per cent over base rate. The discount charge is calculated on a daily basis and usually applied monthly.

Credit management fees

There will be a fee for credit management and administration. The amount will depend on your turnover, the volume of your invoices and the number of customers you have.

Typical fees range from 0.75 per cent of turnover to 2.5 per cent of turnover.

For invoice discounting, fees are typically lower than for factoring because you will still collect and manage debts yourself. They generally range from 0.2 per cent to 0.5 per cent of turnover. These fees are less because the level of service provided is significantly lower than with factoring.

Credit protection charges

These will be levied in non-recourse factoring arrangements, where the factor is liable for any bad debts. The amount will largely depend on the factor’s assessment of the level of risk.

Typical charges range from 0.5 per cent of turnover to 2 per cent of turnover.

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Export factoring

Some factoring companies offer a facility for the financing of international sales. They will typically work with a partner abroad who will be responsible for the collection of payment in the country to which you export. The services of a local agent will prevent any problems that could arise because of differences in laws, customs, language and time differences.

In terms of credit limits and process, there is no material difference between local and international factoring.

Some factors will offer you the choice of being paid in sterling or in another currency. You should carefully evaluate which is to your advantage. If your customer insists on being invoiced in their country’s currency, consider investing in protection against currency fluctuations. Factors may approve a lower level of prepayment for export invoices than for local sales.

Requirements for export factoring

• You normally only need to have an annual turnover of at least £100,000. This can include domestic sales.
• Companies based in the European Union (EU) can still factor debts owed from other EU countries if sales within that country are relatively small.
• Outside the EU higher sales to a single country will be required. For the USA annual sales of £500,000 will typically be necessary.

Export factors will usually charge more if the volume of sales is low.

Features of export factoring

• You can choose to invoice in one currency and be paid in another. Many customers prefer to be invoiced in their own currency.
• You can be protected against currency fluctuations.
• The cost of export factoring is usually slightly higher than the cost of domestic factoring, but less than the cost of export finance.
• You can minimise the bad debt risk by purchasing credit protection. Most factors insist on this.

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How to choose a factor or invoice discounter

There are a variety of providers to choose from when considering factoring or invoice discounting, including subsidiaries of major banks and financial institutions, or independent providers.

You need to be able to make an informed choice, so it’s worth approaching more than one company before making a decision.

The Asset Based Finance Association (ABFA) maintains a list of providers, with details of their turnover requirements and the services they offer. Find information on factoring providers on the ABFA website- Opens in a new window.

There are also a number of brokers that can negotiate on your behalf. They may not charge you as they will receive commission from the provider.

Providers should be willing to let you talk to some of their customers to gain references, and you should pay attention to a provider’s reputation when considering using them.

Questions to ask

• What is the funding provider’s record in collecting debts quickly and efficiently?
• How exactly does the provider operate? What are the procedures in detail and do they suit you?
• How does the provider handle disputes and queries?
• As the factor will become an ‘insider’ and be in frequent contact with you and your staff, do you see eye to eye on issues that are key to your business? Do you have a good initial rapport?
• Does the provider have experience of your industry?
• How is the provider likely to communicate with your customers (if it is a disclosed arrangement)? You should agree a general customer service policy with them to ensure they will not alienate your customers.
• What will happen if a customer goes over the credit limit?
• What happens if you want to end the agreement? What period of notice must you give? Most providers require three months’ notice, but some have notice periods of up to a year which could be expensive for your business.

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Supplier finance

Supplier finance – or ‘reverse factoring’ – is used to provide low-cost finance to both a business and its suppliers, as part of a flexible settlement system.

It works by providing early payment to a supplier on an approved invoice – either by a bank or a factoring company – which is then repaid to the bank or factoring company by the business.

Once the buyer approves the invoice, the payment – less a fee – is made immediately (and ahead of terms) by the financier.

As a supplier, this allows quick payment of invoices, and a low cost, low risk method of obtaining finance. However, although you will be paid the invoice ahead of terms, a fee will be payable, which will be taken off the invoice value.

As a buyer, using supplier finance can allow you to support your suppliers and so maintain stability in your supply chain. However, it is generally more suited to large retailers with several suppliers who need paying quickly.

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CASE STUDY

Here’s how debt factoring improved my cashflow

Oxford-based company Media Drive provides an innovative vehicle wrapping service that allows commercial fleet owners to advertise their products and services on their own vehicles. When Media Drive started up in 2003, the company took on the services of a debt factoring company as a positive step towards generating a healthy cashflow. Director Barnaby Smith explains the advantages.

What I did

Make factoring a positive choice

“Like many businesses starting up, we didn’t expect to make profits immediately so managing cashflow was vital. We also knew that we needed to release as much cash as possible for capital investment in our production facility.

“We were wary of debt factoring at first, but our bank talked us through the process and we began to see its benefits as a finance solution. The bank put us in touch with a factoring company. Their recommendation, plus the fact that the company was a member of the Asset Based Finance Association (ABFA), gave us confidence to take things further.”

Build a relationship

“Before we signed an agreement, we visited our factors at their premises to find out more about how they operated and to meet the team we would be working with. It’s important to have trust and a good rapport with your factors, since they will become closely involved with your business. Not only are they handling sensitive financial information, they are also in direct communication with your customers.

“Any debt factoring company worth its salt will want to know about your business too. They can help you assess if your operation is right for factoring or not. The factoring company looked at our business plan in detail, visited our premises and talked to us about our growth plans before agreeing to work with us.”

Calculate costs

“Factoring obviously involves a cost to the business, but in our experience it was good value when compared to the advantages gained. Our factors calculated an initial fee based on turnover. On top of that we negotiated what percentage of any cash advanced would be payable to them. In the early days, the fee and percentage reflected the risk that the factoring company was taking on with a fledgling business. Over the last four years, both the fee and percentage have come down as our business has grown.

“Factoring means we can access the cash owed by customers almost immediately – within 24 hours of an invoice being submitted if necessary. The money is drawn down electronically from the factor, at up to 75 per cent of the invoice value.

“Factoring is a good business discipline for us too. Each month we know we have to plan ahead and make decisions about how much we need to draw down. It keeps financial planning at the top of our agenda and makes us review all our financing arrangements regularly. We see factoring as one of our financial options.”

What I’d do differently

Do it even sooner

“We made the decision to use factoring very early in our business’ development. Looking back, we should have included it in the business plan from day one.”

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