Factoring and invoice discounting
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Factoring allows you to raise finance based on the value of your outstanding invoices. Growing businesses, in particular, often find that factoring is a more flexible source of working capital than overdrafts or loans.
Factoring also gives you the opportunity to outsource your sales ledger operations and to use more sophisticated credit rating systems.
This briefing outlines:
- How factoring and invoice discounting work.
- How to decide whether you should use factoring.
1 Getting started
A typical factoring process may involve the following steps:
1.1 The factor audits your books and accounts to establish that your sales ledger meets its criteria.
- Most companies which use factoring have a turnover of more than £200,000.
- Generally you should not have just a few customers and no one debtor should account for more than 25 to 40 per cent of your business
- Factors only provide finance to businesses dealing on trade credit terms.
- You should be collecting your debts within a reasonable time frame.
- Too many small invoices may make factoring uneconomical.
- Businesses whose sales are declining could find factoring difficult to justify.
1.2 Where credit limits are required by the factor, you and the factor must agree how they will be handled.
- For non-recourse factoring (where the factor protects you against bad debts), the factor will usually set credit limits for each customer.
- Many factors who do recourse factoring do not agree credit limits.
1.3 Once you make a sale, you invoice your customer and send a copy of the invoice to the factor.
- Most factoring arrangements require you to factor all your sales.
1.4 The factor pays you a set proportion of the invoice value within a pre-arranged time.
- Typically, most factors offer you 80 to 85 per cent of an invoice's value within 24 hours.
1.5 The factor issues statements on your behalf and collects payments.
- This includes contacting late payers by phone and pursuing outstanding invoices.
- You remain responsible for reimbursing the factor for bad debts, unless you have arranged a 'non-recourse' facility (see 2.5).
1.6 You receive the balance of the invoice (less charges) once the factor receives payment.
1.7 The factor provides regular reports on the status of your sales ledger.
- You should expect regular statements.
2 The advantages
2.1 You maximise your cashflow.
- Factoring enables you to raise up to 80 per cent or more on your outstanding invoices.
2.2 You negotiate an initial credit line which can grow in step with your sales.
- Bank finance, such as overdrafts and loans secured against existing assets, has to be continually renegotiated.
2.3 Using a factor can reduce the time and money you spend on debt collection.
- The factor will usually run your sales ledger for you.
2.4 You can use the factor's credit control system to help assess the creditworthiness of new and existing customers.
- This is especially useful if you do a lot of business with companies whose turnover is lower than £5.6 million and who do not have to file full returns with Companies House.
2.5 You can purchase 'non-recourse' factoring to protect yourself against bad debts.
2.6 Factoring can be an efficient way to minimise the cost and risk of doing business overseas.
Invoice discounting
Invoice discounting enables you to retain the control and confidentiality of your own sales ledger operations.
You collect your own debts.
- 'Confidential invoice discounting' ensures that your customers do not know you are using invoice discounting.
- You send out invoices and statements as usual.
- The invoice discounter makes a proportion of the invoice available to you once it receives a copy of an invoice you have sent.
- Once you receive payment, you must deposit the funds in a bank account controlled by the invoice discounter.
- The invoice discounter will then pay you the remainder of the invoice, less any charges.
The requirements are more stringent.
- Your annual turnover must be over £500,000.
- The invoice discounter will regularly audit your books (usually every three months) to check that your credit control procedures are adequate.
- You must have a minimum net worth of £30,000.
- Your business must be profitable.
3 The costs
3.1 Finance charges should be comparable to an overdraft.
- Typical charges on the amount financed range from 1.5 to 3 per cent over base rate, with interest calculated daily.
3.2 Credit management and administration charges, including the maintenance of your sales ledger, depend on your turnover, the volume of your invoices and the number of customers that you have.
- Typical fees range from 0.75 to 2.5 per cent of annual turnover.
3.3 Credit protection charges (for non-recourse factoring) largely depend on the degree of risk the factor associates with your business.
- Typical charges range from 0.5 to 2 per cent of annual turnover.
4 The disadvantages
Unless carefully implemented, factoring can have a negative impact on the way your business operates.
4.1 The factor usually takes over the maintenance of your sales ledger.
- Your customers may prefer to deal with you rather than a factor.
4.2 Factoring may impose constraints on the way you do business.
- For non-recourse factoring, most factors will want to pre-approve your customers, which may cause delays.
4.3 You may only want the finance arrangements, but unless your scale of operations is big enough to justify invoice discounting, you may feel you are paying for collection services you do not need.
4.4 Ending a factoring arrangement can be difficult.
- Your only exit route is to repurchase your sales ledger or to switch factors.
- On a practical level, you need to be able to provide an alternative form of financing to make up for the sudden shortfall in your working capital.
5 Before you sign up
5.1 Make sure you are happy with the service the factor is offering.
- How will you communicate with the factor?
- How quickly does the factor collect debts?
- How flexible will the factor's methods be?
- What will happen if the factor's performance is unsatisfactory?
5.2 Discuss how the factor will handle debt collection.
- When will statements be sent out?
- What happens if a customer disputes an invoice?
- How will the factor pursue overdue debts?
- What will happen when a customer's payments are seriously overdue?
- What form will the final reminder letter take and when will it be sent?
- What further action will the factor take to collect overdue debts?
- Will a collection agency be used?
- Will legal action be taken?
5.3 Confirm the terms and conditions for ending the factoring arrangement and make sure they are clear.
- What would happen if you wanted to stop using factoring?
- What would happen if you wanted to alter the services provided by the factor?
