1) In a nutshell
Invoice factoring is a way for businesses to fund cash flow by selling their invoices to a third party (a factor, or factoring company) at a discount. Factoring can be provided by independent finance providers, or by banks.
2) Also known as…
Debt factoring; Invoice finance; Asset-based lending
3) How it works
- The business client enters into an agreement with the factoring company whereby the company will manage their sales ledger and credit control on an ongoing basis for a fixed period (the term of the factoring contract, typically 24 months).
- In return, the factoring company advances some funds upfront when the business client sends an invoice to a customer- typically 70-85%.
- When the end customer comes to pay, the factoring company collects the debt and makes the remaining balance available to the business client, minus their fees.
For a fee, factoring companies can unlock funds tied up in unpaid invoices so that your business receives funds without waiting for customers to pay. This makes cash flow management easier for the businesses that use factoring. Most factoring providers will manage credit control, too, meaning that the business no longer needs to chase customers for invoice payment – something that can save a lot of admin time.
Most factoring companies lock their customers into a long contract whereby all of their sales ledger must be funded through the factoring facility, and these contracts are often costly and difficult to get out of.
Factoring companies will often quote favourable rates and fees at the outset but the addition of extra fees (or ‘disbursements’) on a monthly basis adds considerable cost and makes this an expensive form of finance.
A lot of business clients prefer to maintain their own credit control rather than enter into a factoring facility that insists on chasing their customers for payment. That is because often it is important to small businesses to maintain healthy and friendly relationships with their customers.
Another word for ‘extra fees’. Factoring companies will charge fees for all kinds of ‘out of the ordinary’ services, i.e. same-day bank payments, receiving letters, credit checks, admin errors etc.
‘Disclosed’ vs. ‘Confidential’ factoring
Most factoring facilities are ‘Disclosed’, i.e. the business client’s customers are aware that they are paying invoices to a factoring company. Some are ‘Confidential’, where the customers are unaware.
‘Approval Period’ and ‘Refactoring Fee’
If an invoice is left unpaid by a customer for a certain number of days (the agreed ‘Approval Period’), it won’t be funded by the factoring company. This means that the business incurs an additional ‘Refactoring Fee’ and the invoice is recoursed back to the business (the business will have to pay back any funds previously advanced against the invoice). It is usually a percentage and charged against the invoice value, including VAT.
Stands for ‘Client Handles Own Credit Control’. Some factoring companies will quote based on the business client maintaining ongoing responsibility for credit control.
Credit insurance, ‘Recourse’ and ‘Non-recourse’ Many factoring facilities include credit insurance – these are called ‘Non-recourse’ facilities. This means if the business’s customers default or go into insolvency the funds tied up in unpaid invoices can be recovered. In ‘Recourse’ facilities there is no credit insurance and so in the event of a default the business will have to pay back any funds previously advanced against relevant invoices.
Security – debentures, personal guarantees and warranties
Factoring companies will almost always require security to set up a new facility with a business client. This can include one or more of a debenture against the business’s assets, a personal guarantee from a director or a warranty (similar to a personal guarantee, where a factoring company must legally prove a business client unable to recover its advances).
‘High involvement limit’, ‘concentration limit’ or ‘debtor exposure limit’ All names for where a factoring company demands that only a certain percentage of a business client’s sales ledger can be made up of a single customer. This stipulation can be very difficult for some small businesses where a large proportion of their outstanding invoices are due to one or two customers.