1) In a nutshell
Invoice factoring is a way for businesses to fund cash flow by selling their invoices to a third party (a factor, or factoring company) at a discount. Factoring can be provided by independent finance providers, or by banks.
Around 45,000 businesses in the UK currently use factoring (ABFA as at Q3 2015)
2) Also known as…
Debt factoring; Invoice finance; Asset based lending
3) How it works
For a fee, factoring companies can unlock funds tied up in unpaid invoices so that your business receives funds without waiting for customers to pay. This makes cash flow management easier for the businesses that use factoring. Most factoring providers will manage credit control, too, meaning that the business no longer needs to chase customers for invoice payment - something that can save a lot of admin time.
Most factoring companies lock their customers into a long contract whereby all of their sales ledger must be funded through the factoring facility, and these contracts are often costly and difficult to get out of.
Factoring companies will often quote favourable rates and fees at the outset but the addition of extra fees (or ‘disbursements’) on a monthly basis adds considerable cost and makes this an expensive form of finance.
Many factoring facilities are unsuitable for businesses which deal mostly with one or two main customers. This is due to factoring companies stipulating low ‘concentration limits’. There are often also limits on invoices due to foreign customers for export activity.
A lot of business clients prefer to maintain their own credit control rather than enter into a factoring facility that insists on chasing their customers for payment. That is because often it is important to small businesses to maintain healthy and friendly relationships with their customers.
Another word for ‘extra fees’. Factoring companies will charge fees for all kinds of ‘out of the ordinary’ services, i.e. same-day bank payments, receiving letters, credit checks, admin errors etc.‘Disclosed’ vs. ‘Confidential’ factoring
Most factoring facilities are ‘Disclosed’, i.e. the business client’s customers are aware that they are paying invoices to a factoring company. Some are ‘Confidential’, where the customers are unaware.‘Approval Period’ and ‘Refactoring Fee’
If an invoice is left unpaid by a customer for a certain number of days (the agreed ‘Approval Period’), it won't be funded by the factoring company. This means that the business incurs an additional ‘Refactoring Fee' and the invoice is 'recoursed' back to the business (the business will have to pay back any funds previously advanced against the invoice). It is usually a percentage and charged against the invoice value, including VAT.CHOCCS
Stands for ‘Client Handles Own Credit Control’. Some factoring companies will quote based on the business client maintaining ongoing responsibility for credit control.
Many factoring facilities include credit insurance - these are called ‘Non-recourse’ facilities. This means if the business’s customers default or go into insolvency the funds tied up in unpaid invoices can be recovered. In ‘Recourse’ facilities there is no credit insurance and so in the event of a default the business will have to pay back any funds previously advanced against relevant invoices.
Factoring companies will almost always require security to set up a new facility with a business client. This can include one or more of a debenture against the business’s assets, a personal guarantee from a director or a warranty (similar to a personal guarantee, where a factoring company must legally prove a business client unable to recover its advances).
All names for where a factoring company demands that only a certain percentage of a business client’s sales ledger can be made up of a single customer. This stipulation can be very difficult for some small businesses where a large proportion of their outstanding invoices are due to one or two customers.
7) Next steps