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Invoice factoring

Invoice factoring is a way for businesses to raise money by selling invoices to a factoring company at a discount. Factoring usually includes credit control services, and helps companies release cash from their debtor book. Here’s everything you need to know about invoice factoring.

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Definition

Invoice factoring is a form of invoice finance, designed for businesses that invoice their customers and receive payment on terms. A factoring provider lends against your customer invoices, enabling you to receive most of the invoice cash value immediately rather than waiting weeks or months to get paid.

The amount of finance available will typically be stated as a percentage of your outstanding debtor book or sales ledger, but may be constrained by specific terms such as limiting exposure to a single large customer.

Typically, payments from your customers will go into a bank account controlled by the factoring company, and your customers will be aware that you use factoring. Some factoring providers will give you the option to credit insure particular customers or your entire sales ledger to minimise your exposure to bad debt (this is known as recourse and non-recourse factoring).

Factoring is a subcategory of invoice finance. Other types of invoice finance are invoice discounting, where you remain in charge of your credit control, and selective invoice finance, where you can choose which customers or invoices to finance.

One of the main things to consider about any form of business finance is risk. From the lender’s perspective, factoring is lower-risk because they’ll have more control over ensuring your customers pay you on time. That means that factoring is often what lenders favour for companies with low turnover, a short trading history, or any other challenging circumstances.

Example

Joe’s Business needs help with cash flow and agrees to a factoring facility with a lender. The advance percentage in Joe’s agreement with The Invoice Company is 80%, so when Joe raises an invoice worth £10,000 and uploads it online, The Invoice Company advances Joe £8,000.

As we’ve talked about, one potential advantage of factoring is credit control, so if the customer was late paying what they owed Joe, The Invoice Company would contact them on his behalf and remind them the bill was overdue. In extreme cases, lenders will even take legal action if necessary — these kinds of credit control services are a key benefit of factoring.

When the customer has paid, the money goes to The Invoice Company, and then Joe receives the remaining invoice value minus the Invoice Company’s fees. In this example, Joe would typically pay about £400 in fees, so he’d get around £1,600 once the customer paid. Joe’s customer would also know he was using a factoring provider.

Credit control

Credit control is the process of ensuring your debtors pay you back on time — thus controlling the overall amount of credit you’re offering. It is also the name given to such a service provided by a third party, such as a factoring provider.

A ‘credit controller’ is the individual, often an in-house employee, who chases late payments and generally manages the company’s relationship with debtors.

Credit control is performed by any company that trades on credit. If a firm issues an invoice with a ‘payment due’ period after work is completed, they’ll often have to wait 28 days or longer while they wait for their customer to pay.

If the customer misses the deadline, credit control might mean sending a reminder, or taking legal action if necessary — anything that ensures the debt is paid.

Factoring providers can help you serve your customers

It’s a common misconception that factoring providers are like debt collection agencies — the reality is that they’ll just take over things like payment reminders, and should have a light touch with your customers. In fact, many business owners find that credit control services from their factoring provider frees up valuable time that they can spend on other things. Nonetheless, some business owners prefer to handle their own credit control.

Factoring might be a great fit if you spend a lot of time dealing with the invoicing process and you’d rather spend that time running your business — letting the lender take care of collecting accounts receivable, while you’re using the advanced cash to focus on growth.

Recourse & non-recourse

Factoring is based on the money owed to your business in the form of invoices — but what happens if a customer doesn’t pay?

With a recourse facility, you would have to absorb the cost of the unpaid invoice. On the other hand, with a non-recourse facility the lender would absorb the cost, leaving your business cashflow unscathed. For this reason, lenders often call non-recourse ‘bad debt protection’, because your business is protected from the issue of non-payment. However, as you might expect, this will make the factoring facility more expensive overall because the lender is accepting a higher level of risk.

Choosing between recourse and non-recourse will depend on the relationships you have with customers, and how likely you think a non-payment is. Of course, factoring includes credit control — so you’ll have experienced credit controllers working on your behalf to minimise this possibility — but it’s worth considering whether the risk of a recourse facility is worth the lower cost.

Rates & fees

With factoring, the costs are calculated a bit differently compared to business loans. Rather than a fixed monthly payment, the fees you pay are calculated based on how much of the facility you have used, and the amount of work the lender puts into your account. There are two elements to the cost of factoring which you need to consider.

Discount rate

In our definition, we established that technically speaking, factoring isn’t a loan, but rather a purchase of your accounts receivable at a discount. In other words, the lender buys your invoices for slightly less than they’re worth. This is called the discount rate, and although it’s technically not the same as an interest rate, it works in a similar way.

The discount rate is calculated as a percentage of what you use each month, and the rate you get is based on lots of factors, including risk, complexity, and the creditworthiness of your customers.

For example, if your debtor book typically has a large amount of small invoices, this will require more credit control work than a handful of large invoices, and therefore your discount rate may be higher. The lenders will also consider the overall risk profile of your business and your customers.

Service fee

The service fee is more like a standing charge — it covers the ongoing servicing of your factoring facility. It’s calculated based on your factorable turnover, so the higher your turnover, the lower the percentage rate. The smallest companies will usually have the highest service fees, because they’re seen as higher-risk than the large companies.

Rates example

The total cost of a factoring facility is calculated by combining both the discount rate and the service fee. Let’s look at an example of how it works in practice, for a business that finances £35,000 of invoices each month.

This level of invoicing would suggest an annual turnover around £300,000 (factorable turnover, rather than total revenue). With a service fee set at 2%, the yearly servicing cost would be £6,000, or £500 per month.

Then, the discount rate would be applied to that month’s invoices. With £35,000 of invoices going through the facility each month, and a discount rate of 2.5%, the monthly discount rate would be about £75.

Adding together the discount rate and the service fee gives us a monthly total of £575 — which would be the total cost of getting advances on £35,000 worth of invoices.

Flexibility

Usually, these fees and rates are adjustable — if your business grows significantly and starts processing £60,000 of invoices per month, you might be eligible for a lower service fee. Equally, your discount rate might be lowered if your instances of late payment and bad debt went down, or if you started working with a large and creditworthy business.

Also, once a business has reached a certain size, it’s often cheaper to switch to invoice discounting, which is more suitable for large businesses.

Overall, it’s worth regularly reviewing your factoring facility to make sure it continues to meet your needs.

Factoring companies

There is a wide range of factoring companies (also known as ‘factors’) on the market. Each of the large high street banks provide factoring, although some banks will only work with their existing business clients, and many are very choosy about which firms they offer it to. Beyond the major banks, there are as many as 100 factoring companies in the UK, ranging from small local providers with a few dozen clients, to large providers with thousands of customers around the country.

Here are the main categories of factoring companies, and their benefits:

Traditional high street banks

The vast majority of UK firms have their business current account with a small number of major high street banks, all of whom offer factoring. Some mainstream banks only actively offer factoring to their customers, and most focus on prime lending. Benefits are that costs are typically low, and the large banks are highly regulated.

Challenger banks

This new breed of ambitious banks are looking to break the stranglehold of traditional high street banks, and will almost always offer factoring if they serve small and medium sized businesses. Challenger banks can offer competitive rates (although typically not to the same extent as their larger peers), and these new banks generally have a strong appetite to do business.

Major independents

Some independent lenders have thousands of customers across the UK. Like challenger banks, they generally have a strong appetite to do business, and their deep expertise means that they can often find a way to make deals happen that wouldn’t be possible with the larger providers.

Niche sector specialists

Some firms are particularly known for serving firms in a particular sector, such as recruitment or construction. Unsurprisingly, this sector expertise can mean that they can provide particularly good service, and that they can take an understanding view. Access to senior decision-makers in these specialist factoring companies can be really valuable if your business hits a bump in the road.

Small local providers

Like niche sector specialists, smaller local providers offer a bespoke personal service, and if times are hard then access to senior decision-makers at these smaller companies can make all the difference in getting through a bad patch.

How to compare factoring

Although cost is of course important, it is vital to understand that the lender you choose will have direct access to your valuable customers — meaning that service quality is critical. Equally important, as factoring is designed to improve your working capital and cashflow, the lifeblood of your business, most firms want to be working with a flexible and responsive factor, particularly if your business is struggling or growing quickly. Here are some things to consider when you compare factoring:

  • Service – Does the company offer genuine reviews and testimonials? Are they a member of the Asset Based Finance Association?
  • Price – Don’t just look at headline rates, look at the whole range of fees which can sometimes double overall costs. Some modern providers offer a simple all-in rate.
  • Flexibility – Is there a named representative who will listen if you need some flexibility, for example to meet payroll? Can you easily leave the facility if the service is poor?

Are factoring companies regulated?

Generally, factoring is unregulated, meaning that you will not get the protections we’re all used to as consumers of financial products. However, the Asset Based Finance Association (ABFA) is a voluntary trade association for factoring companies which has a code of conduct for its members, including access to an independent Ombudsman for unhappy customers. Also, many large financial institutions such as banks are expected to follow a general principle of treating customers fairly.

Alternative factoring companies

A number of innovative new factoring companies have emerged offering a new breed of factoring product, often online. One example is spot factoring, in which you can choose to finance just a single invoice. Similar to this is selective factoring, which enables you to choose which customers to factor. As such, both spot factoring and selective factoring are akin to pay-as-you-go (PAYG) factoring, which has obvious cost and flexibility benefits if your cashflow challenges are intermittent. In some cases, your invoices are financed in a competitive bidding situation, called invoice trading.

Invoice finance guide

Invoice finance is a complex area of business finance, so we’ve put together a comprehensive Invoice Finance Guide to help you find the right invoice finance for your business.


Thumbnail: Invoice Finance Guide 2017

The free guide includes in-depth information like the difference between factoring and discounting, the technical terms you need to know, and the standard criteria for invoice finance.

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