Two of the main factors causing problems for businesses today are lack of working capital, and insufficient cash flow. A business needs to buy stock, pay its workforce, meets its running costs, and keep its transport running. Unfortunately, few customers pay their invoices on time; in addition they too might have cash flow issues and so delay paying bills for as long as possible. This is far from ideal for the company chasing payment and which needs the money immediately. Credit factoring can help solve problems with cash flow.
What is invoice factoring?
Invoice factoring is a widely used business practice across many business sectors, whereby companies can contract with a bank or other finance company that offers it. The invoice factoring company takes over the management of it's invoice book and advances a percentage, usually between 80% and 90%, of each invoice as soon as it is raised, subject to an overall limit.
A substitute for an in-house Finance Department
Some companies use invoice factoring providers as a substitute for in-house finance or credit control departments. This is because the financier doesn’t just collect outstanding invoices from customers, they also carry out the work that a credit control team might usually otherwise do, including:
- Credit checking customers;
- Instigating credit control procedures;
- Chasing debts;
- Offer the company protect against bad debt.
How invoice factoring works
1. The company raises invoices, sends one to the customer to which they have provided goods and services, and
a copy to the financing company. Let us say that the invoice is for ₤100,000.
2. The financier will offer an advance, which can be as high as 80% or 90% of the invoice; at 85% the amount advanced would be ₤85,000; and
3. The financier collects the ₤100,000 from the customer, retains ₤85,000 advanced to the company and sends the remaining ₤15,000
less the service/interest charge to them;
4. The company has now received the full ₤100,000, less costs.
Charges for invoice factoring
The financier will charge the company a service charge, applied as a percentage on the amount borrowed; higher borrowing usually attracts a higher charge. Interest is also paid, usually at a rate set above libor
or the Bank of England base rate, depending on the lender.
Advantages of invoice factoring
In addition to invoice factoring being a simple, straightforward way to raise capital quickly, it also carries other advantages. These include:
- The time previously spent pursuing unpaid invoices is saved. Management can use the time to increase sales and make sure that the company is working to maximum efficiency;
- By resolving problems with cash flow, insolvency becomes much less likely;
- The company can save a significant amount of money because, depending on its size, it may not have to maintain its own finance department or credit management team; and
- The financier provides a cushion against increasing bad debts as they employ industry standard credit management systems.
Disadvantages associated with invoice factoring
Although there are not many disadvantages to invoice factoring there are a few, including;
- The service has to be paid for, and ultimately this is deducted from profits;
- Because the financier deals with customers it is clear that the company is using invoice factoring. This shouldn’t matter as it is a widely used business practice. However, there is a slight risk that some customers might take this as a sign that the business is in trouble, and stop trading with the company; and
- Financiers usually offer invoice factoring only on commercial invoices representing business to business trading.
Before contacting an invoice factoring company
Any company considering using invoice factoring should:
- Consider whether they really need it, as costs will eat into profits;
- Make sure that deploying invoice factoring is not used to cover up or hide other problems in the business;
- Get professional advice from a broker before entering into a contract with a financier. This can help the business assess what type of invoice factoring arrangement, if any, would be in their best interests and whether an invoice discounting arrangement might be a better option.
- Choose a financier carefully, ensuring they specialise in invoice factoring within the market the company operates;
- Be very clear on the likely annual cost of the arrangement; and
- Secure an overall credit limit that meets the company’s needs.