1. What is factoring and invoice discounting?
Factoring - also known as 'debt factoring' - involves selling your invoices to a factoring company. In return they will process the invoices and allow you to draw funds against the money owed to your business. They will also take responsibility for your sales ledger.
You can use factoring to improve cashflow but it can also be used to reduce administration overheads.
Invoice discounting is similar but your business retains control over your sales ledger.
Your business may be suitable for factoring or invoice discounting if you have:
- 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
- low levels of debt more than 90 days overdue
Your business may not be suitable for factoring if you:
- sell to the public - factoring is only available for sales to commercial customers
- have too many small invoices
- have too many disputes and queries
- are not a sound, reputable and trustworthy business
- have customers that make part payments or stage payments
- have complex contractual arrangements or warranty provisions
Factoring is more complex than some other forms of funding. You may want to take professional advice before using factoring for the first time.
2. The process
Factoring
Factoring provides a fast prepayment against your sales ledger. It allows you, at a cost, to improve cashflow by effectively selling your unpaid invoices to a factoring company.
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 an agreed percentage of the invoice available for you to draw on
- the factor issues statements to the customer on your behalf. It operates credit control procedures including telephoning the customer if necessary. You will agree how to contact 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, and in non-recourse factoring the factor takes on any bad debts.
Charges
The factor will take a fee when they receive the invoice. They will also charge a ‘discount charge’ which works like interest and is calculated against the balance of funds drawn on a monthly basis.
Invoice discounting
Invoice discounting is an alternative way of drawing money against your invoices that allows you to retain control over your sales ledger.
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 you receive cash from debtors you pay it to the invoice discounter, reducing the outstanding balance and making the remaining amount available.
3. Pros and cons
Pros
- factoring and invoice discounting can boost your cashflow
- prices are competitive because of the number of factoring companies
- outsourcing your sales ledger frees up your time to manage the business
- 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 be an excellent strategic and 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
- factors will credit check your customers and can help your business trade with better quality customers
Cons
- factors will restrict funding against poor quality debtors, so you will need to manage these funding fluctuations
- in order 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
- 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
4. Common mistakes
When entering into an agreement with a factor, it’s important that you understand what costs you are likely to incur, what your contractual obligations are and what your rights are should your circumstances change. Otherwise, you may be faced with unexpected charges later on.
You should compare offers from several companies and get professional advice before making a commitment to a factoring or invoice discounting provider.
5. Funding sources
Factors can be independent, or subsidiaries of major banks and financial institutions.
Use our Finance Locator to search for factoring and invoice discounting opportunities.