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What is factoring?

23 July 2020
Mark Friend
Building & Construction, Accounting & Compliance, Raising Finance, Building a Business
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Factoring is a method used by businesses to raise finance through the sale of their sales invoices to a third party called a factor at a discount.

In simple terms, many businesses provide credit to their client customers. Invoices are raised which can often take 30 to 60 days or longer to collect. Businesses in this situation may find that the work involves incurring significant costs up front for labour and materials, and as a result those businesses can experience tremendous cash flow difficulties while they are waiting for the invoices to be paid.

This is particularly relevant where businesses are going through periods of high growth and find themselves cash starved with all their profits tied up in trade debtors.

In these circumstances it can make perfect sense to enter into a factoring arrangement whereby you sell your book debt to a factor at a discount and the factor collects the book debt themselves.

In theory it sounds fine. In practice it is of course not as simple as it first appears.

Here are eight key points you need to consider when looking at factoring:

  1. Your trade debtor or accounts receivable profile
  2. Industry type
  3. The factor
  4. The limits set on drawdown
  5. The charges
  6. Collection
  7. Insurance
  8. Specialist factoring

Your trade debtor or accounts receivable profile

This is key. The quality of the factor and the rates and limits provided will be dependent on the size of your trade debts, the volume of transactions, the quality of your customers, the credit terms given and the industry type. You are more likely to get a good quality factor if your invoices are of a decent size, the debts can be easily proved and the debtors are blue chip companies with a reasonable credit term. Factors generally look for spread. Having 100 accounts of good size is preferable to just a few.

Industry type

Industry type is also important. Many factors exclude construction businesses due to the problems with operating the Construction Industry Scheme and the nature of invoicing. Factors prefer it if the work has been completed and invoiced, which creates problems in construction such as where there are applications for payments or contractually there are restrictions on assigning debts. Please note however that there are a number of specialist factors who deal with the construction industry.

The factor

As with all businesses not all factoring companies are the same. Over the years factoring companies have established niches, with some specialising in the larger blue chip cases and others in industry specific or higher risk areas of factoring. When choosing your factor it is worth exploring the market and picking one who specialises in your type and size of business and your debt profile.

The limits on drawdown

The headline figure is usually that the factor will advance X% of the debt on assignment, typically 70-80%, with the balance paid on collection. In practice it’s good advice to check out the small print. Individual client customers will probably be set limits for advances based on the size of the debt and the quality of the individual client customer. If a client customer is late in payment there will be clawback clauses (known as debts with recourse).

The charges

The factor will probably specify a minimum monthly charge – this is usually referred to as the factoring commission rate, which is traditionally expressed as a percentage of turnover. This charge will be levied to you to cover the costs of operating the arrangement. Be careful however as the headline figure can often be based on unrealistic turnover targets or debtor concentrations. You might find yourself paying significantly more in additional charges than if you had gone to a different provider who had set a higher factoring commission based on realistic turnover targets and debtor concentrations. It’s important to check out the small print for additional fees. The funds advanced will also have an interest charge which can vary significantly.

Collection

Who will chase the debts? One advantage given by factors in their marketing literature is that they will collect the debts on your behalf. In practice, however, the primary purpose of factoring is to provide cash flow. Although debt collection is a service provided by the factor, it is essential that you keep a close eye on the debt. The factors will report to you and it is your responsibility to consider what additional steps you need to take to assist with the debt collection, and more importantly whether you should continue to trade with a client customer.

Insurance

Insuring the debts or invoice factoring without recourse or non-recourse factoring is also something to consider, and is offered mainly by more experienced and long-standing factoring companies.

In most factoring arrangements when the factor does not collect purchased accounts for any reason within a relatively short time, the factor has recourse to charge back to the client business the net value of an unpaid invoice.

In a without recourse arrangement the invoices issued are covered by credit protection (an insurance plan) whereby if the client customer goes into bankruptcy the debt is covered by the credit protection and there is no charge back to the client business.

These arrangements are expensive and are dependent on the credit-worthiness of your customers.

Specialist factoring

Factoring itself comes in so many forms. Certain factors will carry out spot factoring where individual invoices are factored. You may also want to enter into an arrangement called Confidential Invoice Discounting. This is where invoice financing is arranged confidentially, so that customers are unaware that the business is being advanced funds against sales invoices before payment is received. The business maintains control over debt collection. This is usually cheaper than normally factoring because you are not paying for an outsourced collections department.

Factoring is a powerful and effective way to grow a business, but it does come at a cost so is not right for everyone. The other complication is book-keeping. Factoring adds another layer of complexity to your business, which should not be ignored.

Over the years we have dealt with many companies who have tried factoring both successfully and unsuccessfully. If you are curious about factoring then please talk to us. We can provide impartial advice on the suitability of factoring for you, assist you in setting up a factoring arrangement and advise on how best to account for factoring.

The content in this blog is correct as at 23/07/2020. See terms and conditions.

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