Business Finance Series – What is Invoice Finance? – Part 3
This is the third in a blog series I started a couple of weeks ago, talking all about invoice finance.
As you might imagine, there are a variety of different options available when it comes to invoice finance. They all work in different ways and have different qualifying criteria, but essentially the main types of invoice finance are as follows:
- Factoring
- Spot factoring
- Invoice discounting
- Selective invoice discounting
Over the next few weeks I want to look at each of the options in more detail, starting this week with factoring.
Factoring
Factoring is a financial product that enables businesses to in effect, sell their unpaid invoices to a third-party factoring company who is the lender.
It starts by you as the business owner approaching a factoring company and applying for a facility. The factoring company or lender you approach, will want to understand your business and may request such information as a copy of your latest accounts, up to date management information and the last 3-6 months business bank statements. That said, this level of information is not always requested.
However, one thing a factoring company will request, is a copy of something called your aged debtor list.
The aged debtor list is important, because it provides the factoring company with information about your customers such as:
- How many customers you have?
- Who your customers are?
- What is the amount outstanding to each one?
- How long are you having to wait to get paid?
These are all important questions that a potential lender or factoring company will need answers to, and they can get them by you providing a detailed aged debtor analysis.
Having made the application, and the factoring company having agreed to assist you, here’s how it works.
You have provided goods or services to your customer and have issued them with an invoice. You immediately provide the factoring company with a copy of that invoice. They then pay you against the value of that invoice in two instalments.
The first payment against the unpaid invoice you have submitted, will be at the pre-agreed percentage outlined in your loan documentation when the factoring facility was approved. This amount varies considerably, but typically, can be anywhere between 70% and 95% of the value of each invoice.
The key benefit is that, this first payment provides you with an immediate cash injection into your business, thus giving you instant cash flow that you would otherwise have to wait weeks or even months to receive, if you were awaiting payment of the invoice by your customer.
The second payment is made to you by the lender once your customer settles their outstanding invoice. This second payment is made to you, less the servicing fee that the lender charges as part of the overall factoring facility they have provided.
One important point you need to be aware of when it comes to factoring. The factoring company takes over your credit control process.
This is an important point and means two things.
1. Firstly, the advantage is you no longer need to chase your customer for payment as this is now done by the factoring company. This can be a major benefit, as you no longer have to expend time, energy and ‘head space’ chasing payment of invoices. You have received the bulk of the funds against the value of the invoice and the factoring company has now taken over the responsibility for obtaining payment from your customer.
2. That said, the second thing to be aware of, is that your customers will know you are factoring their invoices. This can lead to a concern amongst your customers, who may draw the conclusion that you are in financial difficulty or are struggling cash flow wise. Whilst this may or may not be true, the point is your customers know you are factoring.
My suggestion to overcome this second point, is to be ‘up front’ with your customers. Tell them you are factoring.
Factoring is now an accepted and main steam source of business finance, so simply explain to them what you are doing and why you’re doing it. I’ve had clients do exactly that, and never had an issue. In fact, particularly if you have a good ongoing relationship with your customers, they will appreciate being kept “in the loop”.
So why would you decide to use factoring as a business finance option? And what are the advantages and disadvantages.
Advantages:
- A quick, and convenient way of accessing funds, thus improving cash flow within the business.
- You no longer need wait 30, 60, 90 days or even longer to get paid.
- It reduces the amount of time and energy you spend on credit control and chasing late payments.
- As your business grows, the amount you can borrow increases against the size of your sales ledger.
- Factoring works for large companies but works equally well for smaller businesses.
- Factoring is available for start-ups and brand-new businesses. This is because, if you have a sales ledger or accounts receivable you can factor.
- You don’t have the long-term commitment of a business loan.
- The factoring facility is a ‘rolling contract’ with the result that there is no limit to the duration of the facility.
Disadvantages:
- It could affect your working relationship with your customers, as they will be aware that a third party is involved in collecting payment of invoices.
- It may limit your ability to arrange additional borrowing elsewhere. This is because the factoring company has a charge over your sales ledger which can be a major asset within any business.
- You lose control of your accounts receivable to a third party, namely the factoring company. For some business owners this is a level of control they are not prepared to give up
So, what are the charges for factoring?
There are two main costs when it comes to factoring. One is the discount fee and the other is the service charge.
1. The Discount Fee works in a similar way to the interest rate on a loan. The discount fee is charged against the amount of funds advanced by the factoring company and is usually based on bank base rate plus an agreed interest rate margin. This will be outlined in your loan documentation.
The discount fee varies depending on the deal, but as a general guide, the discount fee is usually in a range of 1.5% to 3% over bank base rate.
2. The Service Charge is in effect the factoring company’s cost of running your factoring facility. There are several services the factoring company provides, including a credit control function, chasing and collection of invoices and all the administration required to operate your facility.
Again, service charges vary depending on the type of deal and the likely cost to the factoring company of running your factoring facility, but are typically between 0.75% and 3% of your annual turnover and are normally charged on a monthly basis.
These are the main fees a factoring company will charge, and will vary dependent upon such things as: the number of invoices being handled, size of invoices, the industry you are in (some businesses such as recruitment or logistics are ideal sectors for factoring whereas the construction industry is a more difficult sector to factor – although by no means impossible), creditworthiness of your customers and the stability of your business.
Also, bear in mind the factoring company may levy additional charges, such as a minimum usage fee, an early settlement fee or a credit protection fee.
If you are considering taking out a factoring facility, my suggestion is do your research. Ask questions, check the small print and ensure you know exactly what you are getting and what it will cost before ‘signing on the dotted line’.
In summarising the benefits of factoring, the following statistic from quarterly research carried out by UK Finance perhaps says it all:
“As at December 2018, the number of days that UK business who use factoring are having to wait for payment of an invoice is 54 days”
Source: https://www.ukfinance.org.uk/system/files/IFABL-Q4-Update-Press-Copy-final.pdf
Why wait 54 days to get paid when you could factor, and so receive funds up to 95% of the value of your outstanding invoice within 24 – 48 hours.
As I’ve outlined, factoring has advantages and disadvantages. But, when it comes to raising funds quickly to help support the cash flow of your business, it can prove an ideal business finance solution.
Next week I’ll look at “spot factoring”.
In the meantime, if you are currently experiencing cash flow problems within your business and want to talk to an expert, then email us at keith.park@fundingtrack.com or give us a call on 020 8949 2122 and let’s see how we can help.