How do they work?

What to do when you need to use factoring or invoice discounting How do factoring and invoice discounting work? As with most things in life the reality of this type of funding is in practice more complex as not all debt can be used to raise finance and the levels of advance quoted by lenders can be misleading.

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What is factorable debt?

In common with most commercial lending the key factor that determines how much you can borrow is the value of the asset, in this case your debtors, that you can pledge as security.

However not all debt can be factored or discounted. (To avoid unnecessary duplication the generic terms factor and factoring will be used to cover both types of debtor based funding from here on except where there is a specific difference in how they operate.)

Some debt is simply impossible to factor as a lender cannot rely on it as security. This includes:

•                Items sold on a sale or return basis, as the customer can always return the goods and cancel the debt on which the lender has already advanced. For a debt to be factorable there must be a clean sale.

•                Even so, any debt which exists on a ‘pay when paid’ basis as happens, for example, where a customer may be holding a consignment of stock, will not be factorable as the lender cannot necessarily determine a specific point at which the invoice raised will become due and payable, if indeed it ever does.

•                The debt must be due from another business (a business to business or ‘B2B’ sale) as factors are not interested in or set up to collect debts due from consumers (‘B2C’ sales). Factors are also wary of sales to government bodies but some will fund against sales to local authorities or quasi governmental and public sector organisations.

•                The other business must be a genuine ‘third-party’ as factors will all discount any intercompany trading within a group.

•                To the extent that a debt is due from a business that is also a supplier to the business, the lender faces the risk that the customer will set off (‘contra’) any sums that are due to them as suppliers against the debt due to the business. Any such debts will be excluded from the funding arrangement or a reserve placed on the account which restricts the drawdown available so as to cover this risk for the factor.

Even having excluded the above, some business debts are still difficult to factor due to their nature or circumstances which affect a factor’s ability to collect in the debts to repay their lending in the event that the business fails. The main difficulties here come in respect of:

•                Contractual debt for the provision of a service over a long period which involves stage payments such as engineering contracts where a payment of a third with order, a third on delivery, and a third on commissioning is not unusual; or construction contracts which may last for many months with a series of stage payments.

Construction debts are a particular problem as they are normally based on a process of monthly ‘applications’ which are the builder’s estimates of the value of the job completed to date rather than invoices for a definite amount. In construction contracts these ‘applications’ have to be agreed by the customer’s architect or surveyors before the final agreed sum becomes payable, normally within two weeks. The bulk of a construction company’s ‘debtor’ book therefore usually consists of applications which will turn into a debt, but where the value of the debt is uncertain until shortly before it is paid over.

Contractual debt is always difficult to factor; if the supplier fails part way through delivery of a contract, its customer will normally seek to offset the costs of replacing the supplier and any associated disruption costs (which particularly in the construction industry can be quite creative), against the debt outstanding.

As a result there are only a limited number of factors who will provide funding against this type of debt and this is usually at lower levels of advance (say 50% against a more normal level of 75% to 85%, together with a requirement for personal guarantees) as they have less certainty as to both the collectability of any debt and in the case of applications, its actual real value.

•                Some contracts, for example for the supply of materials to a manufacturer for use on its production line, may include ‘liquidated damage’ clauses. They are intended to provide a mechanism whereby the customer can be compensated at an agreed rate for any interruption its production suffers if your business fails to supply it with widgets as agreed. These clauses create problems for factors as in the event your business fails, they give rise to the basis for your customers to offset a claim for these damages against the sums due to you on which a factor has lent.

•                Sales which require extensive after sales service or warranties (such as bespoke computer software) may not be fundable, as again the customer may seek to offset a claim relating to the loss of this support or the costs of replacing it against any debt due which the factor would be looking to collect.

•                Sales to overseas customers can be a problem as the factor’s ability and cost to collect will obviously vary from country to country. Some factors are members of international groups and are therefore able to consider funding ledgers with a relatively high degree of international exposure (of say up to 50%), although even here this will involve an assessment of the spread of the ledger on a region by region or country by country basis. Most of the independent sector is however focused on UK based debt only.

•                Sales to a single or very low numbers of customer can lead to a problem with what is known as ‘concentration’. To avoid having all their eggs in one (or very few) baskets, factors generally like to see their risk spread across a number of debtors with any individual customer making up no more that 20% to 25% of the borrower’s debtor book as in the opening case study. However this is an area where factors differ greatly in their policies and some will fund ‘single debtor’ clients. Otherwise in these situations the lender may allow temporary overpayments but these will usually come at an additional cost.

Advances

The level of advance that you can expect will vary from lender to lender but in general the banks’ factoring arms have a high degree of captive business introduced through their banking colleagues and therefore tend to be more conservative than the independents. As a guide, you might expect a bank-owned factor to advance say 60% to 85% against a normal book, whilst the independent firms may range between 75% to 90%, and will in addition consider providing top up facilities against stock or agreed temporary overpayments of say up to 100% to cover specific items such as a peak requirements at a VAT quarter or exit penalties imposed by another lender.

It is important to realise that these percentage advances should be regarded as the ‘nominal’ level of advance. All factors will only advance against ‘approved’ debt which is to say your total debtor book less the debt that has been disallowed as a result of:

•                aging, when normally any debt of over 90 days old will be disallowed; and

•                reserves placed against the accounts to cover any supplier contras,   balances in excess of agreed concentration limits; intercompany trading; or    individual debtors that the lender won’t fund for whatever reason, such as overseas debtors.

As a result of this disallowed debt, what really matters is your ‘effective’ advance, which is to say the funds available that you can actually draw down from the factor (your ‘availability’), as a percentage of your total debtor book. As you can see from the potential reserves that will be applied above, this will often be significantly lower than the headline percentage advance you have agreed with the lender.

As discussed below this can be a particular issue if your business gets into difficulty.

How much does it cost?

The costs of debtor based finance will include two main elements:

•                A service charge which for factoring typically runs at from 0.5% to 1% of turnover to as high as 3%.

Factoring tends to be more expensive than invoice discounting as the charges include the cost of providing the credit control service (and where applicable bad debt protection) where both the number of customers and the number of invoices being issued come into the equation for determining the costs. These charges are very visible and one of the reasons why factoring has a reputation for being expensive. However if you are comparing the cost of factoring to other sources of finance you will need to take into account any savings you may be making by outsourcing your credit control function.

If you are comparing the cost of debtor based finance to the cost of bank overdraft facilities, be sure to take into account any ‘management’ and ‘arrangement’ charges that your bank imposes, together with the cost of credit control and insurance.

•                Interest costs, which will be quoted at a rate over base and which should therefore be directly comparable with interest rates on other types of lending.

There are however some other costs to take into account which include:

•                any initial audit cost;

•                a take on fee to cover the administrative costs of setting up the arrangement;

•                separate credit insurance costs where the lender may insist that you obtain insurance cover on some or all of your debtors;

•                transaction costs such as telegraphic transfer fees (TTs); and if it ever comes to it,

•                collect out costs.

What happens if you suffer a bad debt?

Most businesses suffer bad debts from time to time but this raises an obvious problem if you are using debtor based finance as you will already have received an advance in respect of the invoice when it was raised, so how do lenders deal with this situation?

Factoring can be on either:

•           a ‘recourse’ basis, where in the event a customer does not pay the lender, can recover the funds they have advanced to you from your current availability, leaving you exposed to the impact of the bad debt; or

•           a ‘non-recourse’ basis where if a customer fails to pay a debt where there are no grounds for dispute, this is the factor’s problem not yours.

Obviously in non-recourse factoring the lender is taking a much greater risk, or will be bearing an expense in insuring the debt which will be reflected in the price of the service.

What you will usually find is the factor will advise you of a credit insured limit for each customer which will be the figure up to which ‘non-recourse’ applies.

So if you had three customers as below who do not pay, the result would be as shown:

Customer Debt due Credit insured limit Impact of failure to pay on your facility
A £10,000 £15,000 The factor’s ‘insurance policy’ pays you out for the debt so you suffer no reduction in facility and the factor then pursues recovery in the normal way.
B £10.000 £5,000 The factor’s ‘insurance policy’ pays you out to cover the first £5,000 so that there is no loss of facility in respect of this, but the factor will claw back the advance made in respect of the further £5,000 in excess of the credit insured limit.The factor will then look to recover the full amount from the debtor and if they do so they will restore the funds to your account.
C £10,000 £0 The factor will deduct the entirety of the advance made against the £10,000 debt which will reduce the funds available to you.

What happens if your business gets into difficulty?

As with any lender, factors and invoice discounters will take steps to manage their risks if they see that your company is getting into difficulty.

A factor has a direct and disclosed relationship with your debtors. This makes it easy for the lender to verify the debtor balances that are being held as security as well as putting them in a good position to collect in the debt if required.

Factoring is therefore seen by lenders as a safer service to offer than invoice discounting. As a result, one step an invoice discounter will look to take if they become concerned, will be to move your account onto a factoring arrangement as a way of giving them a much closer grip on your debtors and their exposure.

Of course, as your facility under debtor based finance is broadly tied to sales volume, if sales fall it follows that the funding available will also fall (which may be just the moment that you need finance the most).

In addition to this ‘natural’ reduction, both forms of lender will look to actively manage down their exposure if they become concerned. They can do so by taking a more aggressive stance in disallowing debt and by placing either specific or general reserves on your account so that the percentage they have actually advanced against your total book reduces. In some cases the effective advance to a company in difficulty can drop as low as 20% of the total debtor book as a result of this sort of approach by a factor’s operations department.

The impact of this approach can be to starve the client business of funds, sometimes to a level which can lead to the strangulation of the business.

In practice factors and invoice discounters can earn good fees out of these types of situations since many charge high rates for forwarding funds by TT, which a business that is short of cash may be forced to pay.

Most invoice discounting and factoring arrangements also have a built-in scale of charges to cover ‘collect out’ situations where they have to recover their money from a business’s debtors following its failure.

In practice this means that a lender’s exposure will often be limited by the time a business finally shuts down because they have successfully restricted drawdown. Meanwhile the failure itself then gives the lender scope to recover their collect out charges which can be highly remunerative.

How does factoring and invoice discounting differ?

In both these forms of finance the lender will provide you with funding known as an advance against the value of the cash due into you from your debtors.

As you then forward them new sales invoices and they receive your debtors’ payments on a daily basis, the total advance they are prepared to give you will change from day-to-day. Deducting the previous day’s outstanding advance from the total advance they are prepared to make today gives you your current availability, which is the amount of cash you can ask the lender to send to you (or ‘draw down’).

While they both involve borrowing directly against the security value of your debtors, factoring and invoice discounting have a number of differences in how they operate. The most important of these are:

•           Visibility and control. In factoring, in addition to advancing you money, the lender also takes over management of your sales ledger and credit control and provides you with the service of actively chasing your customers’ payments on your behalf. This can in itself be an advantage if your credit control has been poor but you will also have to place a notice on your invoices that the debt has been assigned to the factor and that your customers should pay the factor direct.

This means however that your customers will quickly become aware that you are factoring as they will see the notice and will be contacted directly by the lender about their bills, so factoring is normally a very public form of financing.

Because this can cause some businesses concern as to how their key customers are handled, in some cases factors will allow a ‘CHOCs’ arrangement for key accounts (client handles own customers) whereby you retain control of the contact with the customer, while some have also gone on to develop ‘confidential factoring’ facilities.

Invoice discounting differs from factoring in that you continue to run your own sales ledger and collect in your own debtors. As you are continuing to do the work you obviously retain control of the process and it is therefore also possible to have confidential invoice discounting (‘CID’) which means that your customers will not be aware of the arrangement.

•                Live and delayed adjustment. As a factor is advancing you funds against individual invoices and is running your sales ledger, any adjustments to the amount of lending they are prepared to advance, for example as a result of a change in the value of older debt, is made immediately on a day-to-day basis.

With invoice discounting the lender does not run your ledger and instead normally requires you to provide a monthly reconciliation of the account showing, for example, any change in the level of debt over 90 days that will need to be disallowed. The lender will then use this information to make any adjustments required to the reserves. As a result you can find yourself suffering a significant adjustment to the funds available as a single hit on submitting the reconciliation, rather than having a daily series of smaller movements as in a factoring arrangement. While they may amount to the same value in terms of cash of course, the size of the adjustment on a monthly basis may in practice be more difficult to deal with.

This difference is likely to disappear over time as one lender has introduced a service which automatically synchronises the lender’s records with your accounting system on a daily basis and makes the adjustment required. This therefore avoids the danger of a large ‘hit’ following a reconciliation and other lenders are likely to follow suit over the next few years.

They also differ in that as the invoice discounter is not directly in contact with your debtors on a day-to-day basis this is perceived as being a riskier form of finance to offer than factoring. Discounters therefore tend to only want to provide facilities to larger businesses, typically with turnovers in excess of £1m and with a positive net worth on the balance sheet.

Some of the key differences between factoring and invoice discounting are summarised below:

  Factoring Invoice discounting
Visibility Normally public Normally confidential
Debt collection Part of the package You do your own
Adjustments to availability Live Monthly on reconciliation
Application Most businesses with factorable debt Businesses with turnovers of over £1m and a positive balance sheet

Next article: Why Use Factoring Or Invoice Discounting?

Information provided is copyright and subject to the Important Notice on the home page.

Of course the information contained in an article like this can never be a full statement of the legal position as the relevant laws are complex and liable to change. This article can only therefore be a general guide as to the issues involved and as these can have serious implications you should always seek appropriate professional advice on your own particular circumstances before taking any action.

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