Factoring is available for B2B sales made on credit terms and provides fast – usually immediate – payment of your invoices. It allows you to flexibly increase your working capital and improve cash flow by selling your unpaid invoices to a factoring company (usually a specialist finance provider or a subsidiary of a major bank or financial institution).
A factor will typically pay you an immediate advance of say 85% of approved invoices – with the balance to be paid when your customer pays the invoice. You may need to be selective as to which invoices you factor, as under “recourse factoring” you will be required to repay the advance if the customer doesn’t pay the factor within your agreed credit terms. In non-recourse factoring, the factor takes on any bad debts, but will be more selective and will charge you more for the privilege.
There are two main elements to the cost of a factoring arrangement. An agreed factoring fee is taken when the invoice is received by the factor. There will also be a ‘discount charge’ – effectively interest – calculated on the balance of funds drawn and still outstanding, usually charged monthly.
There are several advantages to factoring but you should also be aware of the potential drawbacks.
Advantages of factoring
Factoring provides a quick boost to cash flow. This may be very valuable for growing businesses that are short of working capital.
- 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 in smoother cash flow and financial planning.
- Some customers may respect factors and pay more quickly
- Factoring may well be the standard practice in your industry or sector, and so will have minimal impact on your relationship with customers
- Factors may give you 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 stock purchases..
- Factors will credit check your customers and can help your business trade with better quality customers.
Disadvantages of factoring
Queries and disputes may harm your available funding. For this reason, factoring works best when a business is efficient, sells mainly to larger, established businesses and has few customer disputes and queries. If you supply services or made-to-order products factoring may be less attractive ( invoice discounting could be a better option).
- The factoring fees and discount charges will mean a reduction in your profit margin on each order, so you’ll need to take this into account in your prices
- It may reduce the scope for other borrowings – book debts will not be available as security, so the bank may restrict your overdraft facility
- Factors will restrict funding against poor quality debtors or poor debtor spread, so you will need to manage these funding fluctuations
- To end an arrangement with a factor you will have to pay off any money they have advanced you on invoices if the customer has not paid them yet. This may require some business planning, or raising an alternative source of lending
- Some customers may prefer to deal directly with you, or feel that factoring is a sign of weakness and treat you with caution
- 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.
Confidential invoice discounting works in a similar way, but you retain the responsibility for credit control and debt collection and customers pay you direct, remaining unaware of the involvement of the finance company. This might be a better option if you already have a strong in-house credit control function, or where you can be selective about which invoices you wish to borrow against..