Introduction - customers do not always pay for the supply of products immediately and will rely on efficient credit control process to collect the money. Unfortunately these outstanding unpaid invoices cause a cash flow problem for a company, as they find it difficult to pay their suppliers or internal expenses such as salaries. To alleviate this problem, it is possible for a company to outsource/ sell or 'factor' the credit of unpaid customer bills to a third party factor institution (called an invoice factoring company), in exchange the majority of the unpaid business debt to be paid immediately to the company. This has the effect of speeding up cash flow as well as potentially reducing debt collection administration costs. Rather than have money tied up in unpaid billing invoices, it is released and optimised as cash for good use elsewhere in the business. For new and inexperienced new businesses, this service can provide an insurance policy against bad debt and a useful alternative to balancing cash flow and smoothing financial planning. Factoring is only appropriate to companies that sell products and services on credit terms to other businesses.
Invoice Factoring in the UK - in the UK, over 49,000 businesses use discounting factoring invoice small business services, transacting over £191 billion of invoices per year. It is used by about 8% of all small businesses in the UK and around 60% of businesses with a turnover of less than million pounds. There are dozens of Factor providers in the UK providing factoring services to businesses of all sizes. In the UK, invoice factoring is sometimes referred to as debt factoring. In America, factoring has become known as 'Accounts Receivable' purchasing, 'invoice financing' or 'invoice factoring'.
History of Debt Factoring - the financial practice of factoring dates back thousands of years to the Mesopotamians, who put in place business rules for payments. As civilisations began to expand and develop advanced economies, so they required a more sophisticated means of facilitating the trading of goods and services. For instance, during Roman times, debt collectors would assist merchants to settle debts by creating promissory discount notes. Another example is the Jews financing of Italian crop farmers during the 1500's, (because the time lag of a long harvest meant farmers require cash to survive during the winter). Another example is before the American Revolution, merchant traders of timber, tobacco and cotton were provided advanced funding from European bankers. This minimised cash flow impact of long transportation times between obtaining the raw materials and delivering them to European markets for sale. During the 20th century, factors began to become more flexible and offer different types of services. Benchmarks began to emerge and when recessions occurred and banks consequently tightened lending criteria, Factors began to provide a more effective alternative for small businesses. During the 20th century the most common form of factoring was invented, the credit card. New credit card organisations emerged promising to advance a retailer the money before cash was received from the cardholder.
How Debt Factoring Works - the company receives approximately 80% of the pricing of the cash due from customer invoices outstanding. This main payment which the company initially receives is known as the 'prepayment' or 'initial payment' against the sale ledger. This money is received almost immediately, as opposed to having to wait for larger suppliers to pay trade invoices. In effect, trade debt is purchased onwards by a third-party invoice factoring company. This specialist factoring company also sends out all the relevant invoices and provides all the accounts receivable ledger services, taking away all the stress and hassle of credit control. The factor company will administer the sales ledger, provides daily management cash collection statements of accounts of outstanding debtors (using phone calls and letters). Their role is to maintain a good relationship and goodwill with the company's customers, while at the same time reduce the time customers take to settle outstanding invoices. The remaining 20% of invoice price value is usually paid back to the company, via the Factor, when the customer actually settles the original bill. The balance is simply the initial value minus the value of the invoice. Factors normally charge a 'commission charge' of between the 0.5% and 3% on sales, (depending upon the expected creditworthiness of the companies' clients, the administration costs and risks of managing the sales ledger). When pricing, the factor also it looks at the level of bad debt, size, geographic dispersion and number of invoices outstanding.
Variations of Invoice Factoring - there are variations of the factoring process;
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Recourse factoring - this is where the internal management controls of credit control left in place within the company. As the Factor does not have control, he risks bad debts. Therefore, they will vet the quality of the company credit control personnel, IT systems and business owners before agreeing. To offset the risk of the company's failure to collect monies owed, the Factor insists on contractual recourse against the company (in case of bad debt by the company's customers). This recourse would normally entail a debt buyback clause or invoice swap for a different invoice of similar value, after a set time period elapses without the debtor paying the invoice. To limit problem invoices/ clients, the Factor might also help the company determine the creditworthiness of their customers before setting credit limits.
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Non Recourse Factoring - this is where the Factor accepts the risk of non payment by the company's debtors (suppliers). This means a higher cost to offset risk and allows the Factor the freedom to potentially pursue a bad debtor into court.
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Invoice Discounting - Invoice discounting uses similar principles to factory, in that the company can draw monies against its invoices. It is typically used by larger organisations as a method of raising short term cash more quickly than bank bridging loans. The 'invoice discounter' organisation agrees to pay an advance of 80% of the value of the outstanding invoices at any one point in time. Every month the value of outstanding invoices may rise or fall below the agreed level. This has the effect that the company may owe the discounts are many is or vice versa. It ensures the company has a steady flow of short-term cash inflow available almost immediately. The invoice discounter charges based on the following criteria:-
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Interest - interest is added to the value of each invoice by a couple of percentage points above base interest rates.
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Credit Administration Charges - this is an administration charge reflecting the effort and resources required from the discounter.
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Credit Protection Charges - in situations where a company is using non recourse factoring, the factor usually insists on implementing credit insurance to protect themselves against any bad debts. This cost is passed back to the company.
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Export Factoring - if a company sells its products to overseas suppliers, it will lead to collect monies from suppliers. The main difference is that the 'export factor' will collect monies from these suppliers by invoicing them in their own currency and may offer a guaranteed protection against currency fluctuations.
Is Factoring Different From a Bank Loan? - yes. Firstly, a bank loan involves two parties; a debtor and a creditor, whereas a factoring arrangement also involves a middleman factoring organisation. Secondly, banks lend money to a company based on the creditworthiness of that particular company, whereas a Factor analyses the creditworthiness of the company's debtors (customers). This typically means that short term credit finance from a Factor is more readily obtainable than a bridging loan from a bank. For instance, a bridging loan or business angel equity capital investment may take months to organise, where as cash from a Factor takes days or weeks to secure. Lastly, factoring cash provides additional breathing space for struggling or failing businesses, whereas unsympathetic bank covenants (loan conditions) do not. This extra level of flexibility gives management critical time to salvage a business form a possible corporate insolvency situation.
Advantages of Using an Invoice Factoring Company - the main advantages are as follows:-
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Cash is available almost immediately for short term working capital. This short term cash inflow can scale in direct proportion with sales, whereas a bank overdraft is capped and linked to sales. Cash can be used to offer cash settlement discounts for the company suppliers.
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Internal credit control resources can be reduced or re-allocated.
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The specialist knowledge of Factors provides enhanced credit rating information on prospective clients, which in turn can help to reduce company bad debt.
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The company will benefit from a more focused and professional debt collection methodology. Credit control skills are not usually the forte of newly created start up businesses that need management time to focus on generating turnover and establishing customer relationships.
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Timely cash on the company's Balance Sheet boosts investor confidence in the company.
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Additional security beyond the debtor's book is not normally required. With the exception of a personal guarantee to protect against fraud, a small company owner does not have to risk their home in the normal course of business.
Disadvantages of Invoice Factoring - the main disadvantages are as follows:-
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Customers may be upset or annoyed by possible strong legal language in any correspondence used by factors. Factoring used to be known as the 'last resort', signifying a struggling business. These days this view is less commonly held.
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As the value of 'book debtors' is reduced on the company balance sheet, this can not be used as security to raise additional finance.
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There is a cost to use factors services which eats into profit margins.
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On average, Factors will require three months written notice to terminate their services, potentially impacting existing customer (debtor) relationships.
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The potential for confusion exists in debtors accounts departments, where no experience of Factor principles or practice exists.
Choosing a Factor - due to the complexity of implementing factoring and it impact on day to day customer relations, it is advisable to seek legal advice before contacting a factor. There are many factor providers in the UK. Some are independent and some a business division of major banks. It is sensible to qualify a factor based on the following questions:-
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What is the factors business process in detail?
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What case studies, reference sites and examples can factor provide of efficient debt collection in the company's particular vertical industry?
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What is the termination period between the company and the factor?
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How will the factor resolve disputes from the company's debt as if they cannot or refuse to pay in invoice?
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Do they have good professional, face-to-face and telephone communication skills that will enhance the company's reputation and not damage it?