Using factoring or invoice discounting in practice

What to do when you need to use factoring or invoice discounting If you have decided to take out debtor based finance and have chosen a funder, you will then need to go through a process to take on and adopt your business practices to obtain the maximum advantage from it.

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The ‘audit’ process

The starting point for any lender in setting up a factoring facility is an audit of your debtor book which may be undertaken by their in-house staff or subcontracted out to a firm of accountants. To avoid undertaking unnecessary work, factors will often seek to charge for this audit on the basis that the cost will be refunded if you go ahead with the deal. In doing so, they are often testing how serious you are about proceeding with an invoice discounting or factoring relationship. Some will however take a view on this and may not make a charge assuming that they conclude you are serious.

The information they will normally want to see will include:

1               an aged debtors list as this will show up any problems in the book and any existing concentration issues (so it is worthwhile going through this in advance to ensure any old debts are collected or fully written off in advance so as not to cloud the picture);

2               cashflow forecasts to show the business’s funding requirements going forwards;

3               current/recent financial statements (principally to show the business’s current net worth and profitability);

4               a set of the company’s order, contractual and invoice and delivery documentation (including details of any liquidated damages clauses, warranties and so on);

5               an aged creditors list (to endure that there are not major potential set offs against creditors or suppliers);

6               a summary of the numbers of invoices raised per month;

7               details of the credit notes issued and bad debt experience over the last 12 months; and

8               details of any ‘adverse’ suffered by the company such as Crown creditor arrears, missed mortgage payments, CCJs and insolvency proceedings (actual or threatening).

As well as checking for evidence of any of the issues already discussed such as concentration, overseas exposure, and any contractual debt or liquidated damages clauses, the auditors will be looking at the quality of the debtor book for security purposes and in particular:


Since factors are lending against the security of debts they only want to lend against debts which they are confident will be paid. Where a debt has been outstanding for say three months, almost all factors will conclude that they cannot rely on this debt being paid and will therefore disallow it from their facility. So the auditor will look at the spread of your debtor’s aging. Does your book include large older balances which would be disallowed by the factor? If so, why have these arisen and what is the risk that more will arise in future?

Your accounting system will produce an aged debtors schedule but this can often be produced on the basis of the age of the debt since the invoice was either issued; or fell due for payment.

The age limit to which factors will fund can be either 90 days from the point the invoice was issued or from which it fell due, but they generally prefer the first approach as it avoids any risk of a hidden build up of ‘old’ debt in the ledger or of lending against debt that is not immediately recoverable.

Case study

A company was selling off its surplus Christmas stock at the end of February and in order to do so agreed with the customer that the invoice was not payable until the following November. Their invoice discounter was allowing debt up to 90 days after the due date.

However this was on the expectation that the company’s normal credit terms were 30 days. When the funder realised that some debts were effectively nine months old before they actually fell due for payment this led to a significant increase in the reserves placed against the company’s facility and therefore a reduction in the funds available from drawdown.


In some cases you may be buying from and selling to the same organisation, in which case your customer may have an amount due to them which they may be able to offset against any debt due to you. Factors will therefore disallow debt from their facility in respect of any such potential contras. The auditor will therefore look to match any supplier balances against customer balances on your aged creditor list.

Credit notes.

Factors are wary of the risk that your debtor book can be diluted by the raising of credit notes so that they find themselves having advanced against invoices that are no longer there. The auditor will therefore look at your history of raising credit notes, including the numbers raised, values and reasons, so as to assess the risk.

Bad debt record.

What has the company’s experience been of suffering bad debts? What levels have they run at and for what reasons?

Customer strength.

The factor will obviously take an interest in the credit worthiness of your customers as in the event that the factor needs to rely on their security they will be looking to these customers for payment.

Terms of trade and paper trail.

The auditor will want to see your terms of business and your documentation from opening accounts and receiving an order, through to dispatching the goods, of obtaining proof of delivery and invoicing, to ensure that you have appropriate agreements in place and systems that they can rely on to support the debts against which they are lending.

Customer’s tools.

If you hold a customer’s tools, you can expect some difficult conversations with auditors as to whether this is a good or bad thing in respect of securing payments from customers. Some take the view that this can give rise to customers having a counterclaim, while others take the view that holding a customer’s tools usually helps to ensure the customer pays.

Take on and operation

At an early stage you may receive an ‘indicative’ offer of finance which will be subject to an audit. Once the audit is completed and the results reviewed, if necessary by the lender’s credit committee or underwriters, you will then receive a ‘sanctioned offer’ which is a formal offer of financing.

The lender should then take you and your staff through the process of ‘take on’ and how to operate the account, the details of which will obviously vary from lender to lender.

If you have entered into a factoring arrangement you and the lender will normally undertake an exercise in writing to all your customers to notify them of the new funding arrangements and you will be supplied with wording or stickers that have to be applied to all your future invoices.

As an overdraft is usually secured in practice on your debtors it will usually be necessary to repay this borrowing from the initial advance received from the factor as they take over your existing debtor book.

Operation of your new funding will then be a matter of following the lender’s procedures for:

  • Submitting new invoices raised to the lender to obtain an advance (sometimes referred to as ‘notification’);
  • Drawing down the funds you require from your daily availability;

and in the case of an invoice discounting arrangement:

  • Paying debtor money received into the lender’s trust account; and
  • Preparing your monthly reconciliation of the account on which any movement on reserves will be calculated.

Termination and changing lenders

If you wish to terminate your arrangement you will need to follow the procedures agreed in your contract with regards to giving notice otherwise you may be subject to penalty charges.

If you are seeking to transfer from one factor to another you need to be aware that there is a protocol agreed between the firms and that the new lender will seek an ‘inter-factor reference’ from the old lender. The particular issues that they will be looking for are any suggestion of either of the two great sins of factoring:

Pre-invoicing – or the ‘fresh air invoice’. This is where cash has been raised by a company against an invoice where no goods have in fact been supplied.

This is the most obvious fraud that debtor based finance arrangements (and more particularly confidential invoice discounting where the lender is not in contact with your debtors) are open to. Lenders will guard against this by holding regular debtor audits and contacting your customers to verify invoices.

Any suggestion in a reference that pre-invoicing has taken place will usually be sufficient to sink a deal.

Diversion of cash. In a factoring arrangement the customer will be instructed to pay debts direct to the factor. On occasions customers will still make payments to the company direct.

Where this happens it is your responsibility to pay the cash over to the factors as otherwise you are still borrowing funds in respect of an invoice which is no longer outstanding. If you do not make such a payment you are actually diverting cash that is due to the lender. Again, invoice discounting arrangements, where you are responsible for collecting in the cash and then paying it into a trust account for the benefit of the lender, are much more open to this form of abuse.

If you are seeking to transfer before the end of your current contract as discussed above, you are likely to be liable for penalties. In these situations there may be a deal that can be negotiated between the incoming and outgoing lenders to mitigate these, or if not the new lender will typically seek to provide some assistance through either an enhanced initial drawdown, or in some cases a sharing of the cost of penalties in order to win your business.

Next article: What Are The Alternatives To Factoring Or Invoice Discounting?

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.

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

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