Debt factoring and invoice discounting

How debt factoring works

Factoring provides a fast prepayment against your sales ledger. It allows you, at a cost, to flexibly increase your working capital and improve cashflow.

Factoring is offered to businesses trading with other businesses on credit terms. It is not normally available to retailers or to cash traders.

When factoring starts

Factors can be independent, or subsidiaries of major banks and financial institutions. Whatever their background, they will want to meet you, visit your business, review your financial situation and study your business plan to evaluate your suitability for a factoring facility.

Credit limits might be required - if so, you must agree how they will operate.

After signing the agreement, the factor will typically agree to advance up to 85 per cent of approved invoices. Payment is usually made within 24 hours. Usually all sales go through the factor.

Check the notification period - most factors require three months' notice to end the service, but some require longer. Negotiate if you are not happy with the notice period.

Factoring is a complex, long-term agreement. It is advisable to consult your solicitor on the legal and financial implications of factoring.

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 it to the factor.
• The factor pays an agreed percentage of the invoice to you.
• The factor issues statements to the customer on your behalf. It operates credit control procedures including telephoning the customer if necessary.

When an invoice is paid by the customer

• The customer should pay 100 per cent of the invoice directly to the factor.
• The factor pays the balance of the invoice to you. Fees and interest will be deducted from the payment.

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.

Advantages

Factoring provides a large and quick boost to cashflow. This may be very valuable for businesses that are short of working capital. A business that is owed £500,000 may be able to get £400,000 or more in just a few days.

Other advantages:

• there are many factoring companies, so prices are usually competitive
• it can be a cost-effective way of outsourcing your sales ledger while freeing up your time to manage the business
• it assists smoother cashflow and financial planning
• some customers may respect factors and pay more quickly
• you may be given useful information about the credit standing of your customers and they can help you to negotiate better terms with your suppliers
• factors can prove an excellent strategic as well as 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 and is available for capital investment and funding of your next orders

Disadvantages

Queries and disputes may have to be referred on. For this reason, factoring works best when a business is efficient and there are few disputes and queries.

Other disadvantages:

• The cost will mean a reduction in your profit margin on each order or service fulfilment.
• It may reduce the scope for borrowing - book debts will not be available as security.
• Factors may want to vet your customers and influence the way that you do business.
• It may be difficult to end an arrangement with a factor as you will have to pay off any money they have advanced you on invoices if the customer has not paid them yet.
• Some customers may prefer to deal directly with you.
• 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.
• You have to pay extra to remove your liability for bad debtors.

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Meaning of Factoring: The selling of a company’s accounts receivables, at a discount to a factor that then assumes the credit risk of the account debtors and receives cash as the debtors settle their account.  Factoring arises when there is working capital gap but bank is not financing the entire gap. Here factors finance the balance part.

In factoring an Escrow account or a designated account requires to open where all the payments comes directly from debtors.

The factor recover the payment financed from the said account where payments comes directly from debtors on due date.

Some factors may ask for confirmation from the buyer that goods have being received and there is no rejection. But this is sometime practically not feasible.  

In factoring two concepts exists with recourse and without recourse.

-If the party gives the guarantee to the factor for payment from buyer, it is called with recourse i.e. the factor does not take on the risk of bad debts

- If the party does not give the guarantee to the factor for payment from buyer, it is called without recourse i.e. the factor takes on the bad debt risk

Non-recourse factoring will be more expensive than recourse factoring

There is specialize financial institutions such as SBI Factors, Global Trade Finance, IFCI Factors which gives services of factoring (Domestic as well as International).

Reverse factoring is also possible. In this case discounting of suppliers' bills is done by factor in respect of the client's regular purchases from them.