Factoring: Selling your invoices to a third party financial party at a discount as a form in finance has in one form or another, has been around for about a 1000 years and can be an invaluable source of financing for start-up companies.
We will take a brief look at the two main types of invoice factoring in the UK and then highlight some advantages, disadvantages and potential pitfalls.
There are two main types of invoice financing and while closely related they differ:
‘Debt Factoring’ usually involves an invoice financier managing your sales ledger and collecting money owed by your customers themselves. This means your customers will know you’re using invoice finance.
- When you raise an invoice, the invoice financier will buy the debt owed to you by your customer.
- They make a percentage of the cost available to you upfront. This can range from 50%-90% of the invoice amount.
- They then collect the full amount directly from your customer.
- Once they’ve received the money from your customer, they make the remaining balance available to you.
- You’ll have to pay them a discount charge (interest) and fees
There is a further distinction in debt factoring – If the factoring transfers the receivable “without recourse”, the entire financial liability is transferred to your finance partner and they must bear the loss is your customer does not pay. If you transfer the receivable “with recourse”, you remain on the hook in the event your customer does not pay.
With ‘invoice discounting’, the invoice financier won’t manage your sales ledger or collect debts on your behalf. Instead, they lend you money against your unpaid invoices – this is usually an agreed percentage of their total value [Sometimes up to 90%]. You’ll have to pay them a fee. As they are not managing your sales ledger, this is will be less than the cost of full outsourcing to a debt factored.
As your customers pay their invoices, the money goes to the invoice financier. This reduces the amount you owe, which means you can then borrow more money on invoices from new sales up to the percentage you originally agreed.
You’ll still be responsible for collecting debts if you use invoice discounting, but it can be arranged confidentially so your customers won’t find out.
Both kinds of invoice financing can provide a large and quick boost to your cash flow.
Advantages of debt factoring include:
- The invoice financier will look after your sales ledger, freeing up your time to manage your business.
- They credit check potential customers meaning you are likely to trade with customers that pay on time.
- They can help you to negotiate better terms with your suppliers as your suppliers will have much greater confidence that your cashflow is secure and not solely dependent upon your customer base paying on time.
Advantages of invoice discounting include:
- It can be arranged confidentially, so your customers won’t know that you’re borrowing against their invoices
- It lets you maintain closer relationships with your customers, because you’re still managing their accounts
Some disadvantages of invoice financing are that:
- The cost reduces your profit margins on each transaction
- It may affect your ability to get other funding, as you won’t have ‘book debts’ available as security
If you use factoring:
- Your customers may prefer to deal with you directly
- It may affect what your customers think of you if the invoice financier deals with them badly
If you are considering either using invoice discounting or factoring for your business, what are some of the issues that you may face:
Set-Up Costs: Set-up costs can be very high. You are likely to have to pay a one-off fee to set up the facility, it may be a lump-sum or a percentage of the facility (typically 1% of the facility size). One has to think beyond just the initial fee that a factor may charge because extensive legal work may be required to set up an initial facility and this can add to your costs substantially. You may also enter seemingly innocuous terms at the beginning, (for example pledging not to sell a certain machine) but then may need to modify them which will require costly lawyers.
Concentration Limits: A factoring firm will typically impose concentration limits, so one has to consider if this is right for your business.
A concentration limit indicates how much debt an invoice finance funder will allow with a single debtor. By way of an example if your concentration limit is 30% and your total ledger is £100,000 then the lender will only consider £30,000 of funding with any single debtor. Supposing you had £50,000 of debt with your largest debtor then only £30,000 would be considered as eligible debt. This would reduce the total eligible debt to £80,000 so if your prepayment was 85% the funding generated would be £68,000.
It is important to understand the impact of a concentration limit on your funding. In the example above although you as a business have an 85% prepayment level the impact of the concentration limit has reduced the actual prepayment level to just 68%.
Concentration limits will not be an issue for many businesses who have a good spread of customers. However, if you feel that one customer could account for 20% of the money owed to you at any one time it is important to consider the concentration limit. Some lenders impose a rigid 20% concentration limit while others will offer a concentration limit as high as 100% meaning they will finance a single debtor. Be honest with yourself and try to envisage what may happen in the future.
Credit Limits: Closely related to the concentration limit is that you must consider the credit limits that a firm may apply to your debtors. If your customer base is not well known or well established the finance company may be reluctant to grant them credit (Remember the factoring firm is essentially making a call on your customer’s credit worthiness). If your customer based is widely spread geographically, you may also spread, your factoring firm may only grant credit to customers in certain countries.
Facility Limits: Based upon your individual business, your factoring firm will likely impose an overall facility limit. You want to ensure that this is large enough for the level of receivables that you intend to factor but you also should remember that you may also be paying an annual facility fee which can range from 0.25% -1.5% of your limit, so having an unnecessarily high facility limit that you will not be using can be very costly.
Business Knowledge: There are literally thousands of different types of firms offering invoice discounting and factoring services. It is important to align yourself with a firm that understands your industry, your business and most importantly your customers. Otherwise you face the prospect of being with a factoring firm that, due to lack of knowledge, perceives your customers as “riskier” and thus not extending the levels of credit that you had hoped. With one technology firm that I have worked with their invoice discounted provider classified many of their clients as “construction” (which they were not at all –but again this was due to a lack of understanding of the business) and thus would only extend 60% versus the expectation of 90%
Fees: One has to be vigilant on fees as they are numerous. Typical debt factoring charges are 0.75%-3% of the total value of the turnover that you put through the facility, while in invoice discounting the normal range is 0.5%-1.5%. So if your clients tend to pay very promptly or even early anyway, this can be very expensive for very little gain. You may also be charged a one-off fee per new customer and then depending upon your arrangements you may be charged separate fees for each invoice added to the facility. In general, if you have a large number of customers that you send small invoice too, this form of finance is unlikely to be economical. Other possible fees, which can all add up to be aware of include termination fees if you decide to end the arrangement with your factor, a refactoring fees (which is an additional fee if debts reach a certain age) and BACS charges. Remember, these are all in addition to the interest you are paying on the amount in the facility which currently ranges from 7%-12% (on an annualized basis).
Holdbacks: If you are going down the full debt factoring route, you should be aware that any merchandise returns that may diminish the invoice amount that is collectable from your customer and the factor will typically have a holdback, until the return period for merchandise expires.
Covenants: Depending upon the type of facility you enter into, you need to be careful with the covenants both positive and negative that you provide to the financing companies. In certain instances you will be providing a charge against all your fixed property, which can then impact your ability to raise other types of finance in the longer term. In other instances, you may have such EBITDDA covenants or will restrict our ability to alter the capital structure of the company (i.e. a capital raise). If you are a start-up business, you may also be required to give personal guarantees as well
Relationships: Your bank may not be willing or able to provide factoring services. If you do choose another bank as your invoice discounter, they may require you to move your entire banking relationship to them. This may be problematic if you have a solid relationship with your existing bank that provides other services to your firm. It could also be costly, especially if your new bank, though providing you with factoring services is charging you more for other banking services such as overdrafts or foreign exchange.
Sales Cycle: Many factoring facilities impose minimum balances (or minimum effective interest to the factor). If your sales cycle is lumpy, you may end up in the situation where you are paying fee/interest despite having no outstanding accounts payable.
Total Costs – While it would appear obvious, you have to consider the total costs of your factoring relationship. Set-up costs, handling fees, interest rate, relationship costs all have to be considered as a whole. If you have a strong customer base, with tight credit terms that pays on time, you have to give consideration to whether a simple overdraft would be a better option.
In closing, the use of factoring to obtain the cash needed to accommodate a firm’s immediate cash needs will allow the firm to maintain a smaller ongoing cash balance. By reducing the size of its cash balances, more money is made available for your firm’s growth. It is also very useful if you have a lot of accounts receivable with different credit terms to manage. However, you have to take a good look at the nature of your business and the total costs that a factoring relationship can incur to determine if it is right for your business.
Author: Ashok Parekh, Director
Thanks for input from John Rowland, Managing Partner