Business Helpsheets
Back to HelpsheetsThe Essentials of Factoring and Invoice Discounting
As many businesses do, you may find yourself operating perilously close to your overdraft limit on an almost daily basis with the stress of cash management taking its toll. You are stressed and you feel like your business cannot grow whilst being restricted by its cash flow problems. You have considered a bank loan but maybe something else would be more suitable- maybe factoring or invoice discounting is the answer to your prayers?
First of All - What exactly is it?
Both factoring and invoice discounting involve passing your debt on to a factoring company who then release a percentage of the value of the debt to you immediately. The percentage can be as high as 90% but this will depend on the factoring company you use. This means you effectively have most of your sales paid straight away by the factoring company.
What is the difference between factoring and invoice discounting?
The main difference is the control over the sales ledger. Factoring your debts will mean that you hand responsibility of your credit control over to the finance company. In invoice discounting, you retain responsibility over chasing debts. In both cases the finance company will pay you a percentage of the value of your invoices.
Do I keep the risk of my debts going bad?
Factoring companies can offer to take on the risk of the invoice going unpaid as part of the service, which is known as non-recourse financing. Should a customer not pay an invoice, the factoring company will bare the cost. This is not the case however if there is a genuine dispute. Non- recourse financing is more expensive than recourse financing.
Is it suitable for my type of business?
New businesses without a trading history who don't qualify for other sources of lending may find Factoring/Invoice Discounting to be the solution to their funding needs.
Also companies working on tight margins with long credit terms to customers may require quick access to funds on a regular basis.
Companies who operate a cash-based or retail-type business do not usually qualify.
The Positives
- Cash flow is the life blood of any business. Profitable businesses will struggle without positive cash flow. Businesses whose credit terms for customers are longer than those given by their suppliers will need to fund the time delay. Where margins are tight, there may not be enough profit on historic sales to fund the time difference. Factoring/invoice discounting means that the cash is provided up-front, giving essential positive cash flow to any business.
- Using a factoring company means that credit control is provided. This may free time which may be better used elsewhere. It also puts a third party between you and your customer which keeps the debt control outside your working relationship with the customer.
- Factoring companies have teams of people who are experienced in dealing with credit control. They also have access to a legal team should legal action become necessary to enforce payment which saves having to shop around for a good legal professional yourself. Customers may also be less likely to delay payment when a professional company is involved.
- Credit checks will be carried out by the factoring company. This should give you advance warning of any potential issues.
The Negatives
- Cost
- Factoring- As with all types of finance, interest is payable. Different companies charge different amounts, so it is advisable to shop around. Interest rates typically range from 1.5% to 3% above base rate. There will be a separate charge for credit management, which is usually based on the turnover. Again, costs can vary but can range from 0.75% of turnover to 2.5%. Should you choose non-recourse factoring there will also be a charge based on the assessment of risk taken on by the factoring company. Typical charges range from 0.5% to 2% of turnover.
- Invoice Discounting
- Interest is still charged but credit management costs can be much lower as there is far less service provided. Fees can range from 0.2% to 0.5% of turnover.
- Ensure you get a list of all the possible charges made by the factoring company: check if there is a minimum fee and whether they charge a fee for withdrawing cash. Some lenders also charge to cover their cost for auditing the ledger.
- Minimum terms apply to factoring or Invoice Finance arrangements, typically a minimum of 12 months.
- Factor all debts: Any arrangement with a factoring company will mean that all credit invoices should be factored. Customers who pay on time will also have to be included.
- Relinquish responsibility of credit control: Although a benefit of factoring may be that you can use a professional for credit control purposes, this means that your customers will be dealing with an outside organisation. Some customers who are used to dealing with the same person may not like the change. You also lose control of the tone of chasing your debts which can damage some relationships.
- Payments are made to the factoring company: it seems obvious but your customers will have to send payment to the factoring company. Some customers may make assumptions about your business when a factoring company is used.
- Dependence: You may become dependent on the instant cash flow a factoring agreement can give. Should you wish to end the agreement, you will need to fulfil all obligations which may be difficult.
- Mortgage/Charge issued on the company. When a factoring company is appointed they will apply a charge over the book debts of the company. This may affect your ability to raise finance from other sources.
Anything else I need to take into consideration?
Many factoring companies have online portals to enable their clients to add information from their sales ledger. The invoices are added per client and then once the invoice is processed a percentage of the sales invoice is paid into your account. The process is quick and easy and can encourage you to raise sales invoices in a timely manner.
For companies operating a cash accounting system for VAT, the invoice is classed as paid when it is settled with the factoring company, not when you draw down the cash. Therefore you still retain the benefits of using cash accounting.
Competition between banks means that if you shop around you can get a good deal.
The Asset Based Finance Association (ABFA) is a body which gives a list of the Factors and their conditions. This is a good first port of call. There are comparison websites for factoring which can compare the various lenders. This could also save a lot of time.
You could also speak to your local business forum or Chamber of Commerce as they may have deals for members that would offer even greater savings.
How we can help you
Speak to us first. Consider whether you really need factoring or perhaps an alternative kind of finance would be more appropriate.