Factoring for growth
Factoring provides cash to your business with no time delay from issuing invoices as well as sales ledger and collection services.
For many SMEs outstanding invoices are their largest asset. Most SMEs do not have the resources and information systems to efficiently collect their outstanding invoices. Factoring can be a smart alternative to transfer the debt collection and ledger management to a factor and almost immediately get cash advances with the issuance of an invoice. The cash can be used to reduce your own debt or for investments to grow your business.
The industry - although often unknown - is quite large (over £60 billion turnover was factored last year). Factoring companies exist as divisions within most commercial banks, as divisions of large financial institutions, as small to mid-sized independently owned companies, and as services offered by individuals.
How It Works
Factoring works as follows: The factor fully manages your sales ledger and provides you with credit control and collection services of all your outstanding debts. The invoices you issue upon a sale are sent to the factor who typically advances up to 80 to 90% of the invoice amount to you. The balance, less charges, is paid when the customer makes payment directly to the factor. The service is disclosed to your customer who typically receives a letter from the factor, or attached note to your invoice, containing payment instructions to the factor.
Funds are typically released to you within 24 hours of issuing the invoice.
There are typically two costs involved: a service charge expressed as a percentage of sales factored and an interest charge for the cash advances. The service charge, covering sales ledger management, collections services and, if you wish, bad debt protection can range between 0.60% and 3.0% of turnover. The main considerations in determining the service charge are your annual turnover, number of invoices and number of customers. The interest charges calculated on the daily usage of funds is typically comparable to normal secured bank overdraft rates.
When the risk of bad debts remains with you the service is referred to as recourse factoring. Non-recourse factoring protects you against customers who fail to pay. The factor typically covers this risk by taking out credit insurance. The cost of the credit insurance is passed on to you and depends on the risk profile of your customers and the amount you factor, typically between 0.3% and 0.7% of turnover. You also agree on coverage limits with the factor, normally 80-95% of the factored amount.
Many factoring companies provide Internet access to your account, allowing you to constantly monitor your sales ledger and individual customer details. Paper can be eliminated by electronic transfer of your invoices from your PC to the factor.
Choosing Between Factoring & Invoice Discounting
If your business is already large enough to afford the staff and information systems to efficiently manage and collect your outstanding invoices you may want to consider an invoice discounting rather than factoring service. It is identical to factoring except that the sales ledger management - the collection responsibility - remains with you. The service is undisclosed to the customer.
Again there are two costs: An administration charge, either a flat fee or a percentage of turnover and an interest charge for the cash advances.
Rule of thumb: if your business has an annual turnover of more than £1 million and an own accounting system, you may want to look at invoice discounting.
* Instant Cash. 80-90% of your issued invoices are prepaid within 24 hours.
* Sales ledger management and debt collection. The factoring company does it for you.
* Factoring rivals and often replaces the traditional bank overdraft. In addition to all the credit management services, a factoring facility grows with the business and does not need renegotiating every time an increase is required.
* Costs money: Service charge and interest charge need to be compared with the cost of fulfilling these tasks by yourself and funding your cash needs through traditional banking facilities.
* Factoring service is disclosed to your customers. It is therefore very important that your factoring company helps you build a long term customer relationship by collecting the invoices in the same courteous and diplomatic manner you would.
Things to Watch out for:
* Term of Contract and termination clauses. A typical contract with a factoring company runs 12 months or more. After the initial term, contracts can be terminated - there are no set rules, read carefully (varies from notice periods to contract anniversary). Termination is always subject to full repayment of the funds.
* Trial period. Some factoring companies have a trial period when you begin using their services: "if you don't like it", you can end the contract after the first few months. Termination is always subject to full repayment of the funds.
* Reputation and references. The factoring company will be a critical interface with your customers. Make no compromises. Work with a reputable firm to eliminate all risk of negatively influencing your customer relationship. Ask for references. Check if the factoring company is a member of the Factors and Discounters Association.
* Personalized service. Particularly if you are a small company, make sure to have a customer service team available for you.
* Exports factoring capability. If you export make sure the factor has its own network, or affiliate partners, in your customer's country to provide on the spot collection.
* Bad debt protection. Some factoring companies offer this additional service, some don't. Ask!
* Chose the factoring company according to your customer profile. Whether your customers are other businesses, or individuals is an important criteria in choosing your factoring company.
* Transfer restrictions of your outstanding invoices. Make sure there are no existing contractual arrangements disallowing the transfer of your outstanding invoices to a factoring company. For example a loan that is secured by your outstanding invoices.
* Information requirements to open an account with a factor. The factoring company will ask you to fill in an application form and provide additional documents and accounting statements you would also typically give to your your bank when taking out a loan. Be prepared to give a detailed overview of your customers, and if you request bad debt protection, their risk profile.
Frequently Asked Questions (FAQs)
What does it cost?
Service charge of 0.6% to 3.0% of sales factored and an interest charge for the cash advances calculated comparable to normal secured bank overdraft rates.
When do I receive the cash advances from the factor?
Typically within 24 hours.
How much of the invoice amount is advanced?
Typically 80 to 90% of the invoice amount.
What is the difference between factoring and invoice discounting?
Both provide immediate cash with the issuance of invoices. Factoring includes a full sales ledger service management and debt collection service that is disclosed to the customer. In invoice discounting the sales ledger management - the collection responsibility - remains with you. The service is undisclosed to the customer.
What is the difference between recourse and non-recourse financing?
Recourse factoring excludes bad debt protection. In the case of non-recourse factoring, if the customer fails to pay the invoice, the factor will pay you.
What is invoice finance?
Another phrase for factoring and invoice discounting.
Bank Overdraft - An alternative to factoring without the credit management services.
Credit Insurance - Insurance in case your customer fails to pay the invoice. You receive payments for your bad debts up to pre determined limits.
Factoring - Instant cash upon issuing invoices and sales ledger and collection services.
Invoice Discounting - . Instant cash upon issuing invoices without sales ledger and collection services.
Invoice Finance - Another phrase for factoring and invoice discounting.
Non-recourse Factoring - If your customer fails to pay the invoice, the factor will pay you. You pay an additional charge to cover the credit insurance costs.
Recourse Factoring - If your customer fails to pay the invoice, the factor will look to you for reimbursement of any amounts advanced against the invoice. The service excludes bad debt protection.