Factoring (or invoice factoring) is a type of short-term business finance or cash flow finance option in which a company’s accounts receivable ledger is sold to a third party (or a factor) in exchange for instant capital. The factor then takes on responsibility for credit control and collection of the debt. In this article, we’ll look in detail at the world of factoring, the pros and cons and its key differences to other types of business finance like a business line of credit.
Invoice factoring is often known by various names including accounts receivable financing, invoice financing or debtor finance. These terms, however, technically describe the broader category of which factoring is only a specific type. We’ll outline an alternative to factoring, invoice discounting, and highlight its several key differences below.
Factoring comes right out of the pages of history. Whilst the earliest records stretch back 4,000 years ago to the ancient Mesopotamians, it was the Romans who got receivables finance started when they formed and employed the first specialist debt collectors. In fact, the word factoring comes from the Latin facere. Throughout the intervening centuries, it has evolved into the industry that we know today helping Australian businesses manage their debtors and outstanding invoices.
What is factoring in business?
Recruitment and labour-hire - an example
A labour-hire business supplies temporary workers to various firms. These workers remain contracted to the labour-hire company who pay them weekly based on the timesheets they complete. These timesheets are then invoiced to their clients. The clients have payment terms of 30 days to 60 days which means that the labour-hire business must wait for the cash they are due. They must still meet payroll weekly and this wait for their debtors to pay their invoices creates a cash flow gap. Cash flow gaps restrict a business’ ability to cover day to day costs, take on new clients and grow. This is where an invoice factoring company comes in. An invoice factoring company will offer cash up-front by buying an accounts receivables ledger.
How it all works
When a business’ invoice ledger is purchased by the factoring company, that business receives an advance cash payment for each invoice, typically of 70-85%. The funds are transferred quite quickly, often in 24 hours. It is then the responsibility of the factor to chase payment for those outstanding invoices. Once a debtor pays an invoice, the business who sold their accounts receivable ledger receives a second payment called a rebate. This rebate is the remaining balance of the invoice, minus the factoring fees which generally range from 1.5% - 4.5%.
Factors can be banks or independent finance companies. Factoring facilities tend to have long lock-in contracts, usually 24 months, and typically all invoices must be sold as part of the arrangement. The factor is responsible for credit checking customers, chasing payments and dealing with a business’ client base on behalf of that business.
It provides businesses with quick working capital allowing them to continue trading. They can pay staff, cover operating costs, expand, and meet their order demand.
A factoring facility is often available to businesses for whom other types of financing are unavailable. There are, however, various checks a lender will carry out to assess suitability. These include:
- Industry - Not every industry is suitable for factoring. They need to invoice other businesses. Industries usually include manufacturing, recruitment and labour-hire, transport, logistics, wholesale and distribution.
- Credit history of debtors - Whilst a factor will look at your business creditworthiness, they will also be interested in knowing more about your clients from whom they will be collecting the funds.
- Age and concentration of ledger - These are important for determining risk from your debtors. An invoice factoring company look at how overdue your invoices are in order to assess how easy collections will be. It is more valuable to have many debtors spread out over your ledger rather than a concentration of only a few. The risk the factoring company assumes is not getting paid from your debtors, so there is less risk when there are more debtors, more risk if there are only a few who default.
These factors will determine not only eligibility but also the interest and advance rate.
The pros and cons of invoice factoring
|Improved cash flow, allowing you to fulfil orders, pay staff, cover operational costs and grow||Usually requires a long term commitment (24-month contract)|
|It grows as you do. As more invoices are raised, the amount available increases||It can be expensive (compared to other types of finance)|
|Fast funds - often the business receives funds in 24 hours||The credit limit is capped by the value of the invoices|
|It’s not a business loan in that it doesn’t require any fixed assets as collateral||It can have a bad reputation because it exposes your cash flow situation to your clients|
|Includes back office support (credit control, collections)||Your precious customer relationships are in the hands of a third party|
|It can offer protection against bad debts (non-recourse). If the customers you are invoicing fail to pay, credit insurance is available||There are hidden costs (known as disbursements)|
|Suitable for small business – it can be available when other forms of finance are not||They often don’t take bad debtors (recourse factoring)|
|It is relatively quick and easy to get funding, with minimal paperwork (compared to other forms of finance)||Low concentration businesses are generally not suitable|
|It reduces the need to raise capital in other ways|
Are there alternatives to invoice factoring?
Yes. An alternative to invoice factoring is invoice discounting. It is similar and it offers many of the benefits of factoring such as instant working capital, no fixed asset requirements, relatively quick and easy application process, but it comes with one main difference: you stay in control.
Invoice discounting companies remain in the background of your day to day operations. Debtors pay into a bank account the discounting company has set up for you. Collections and customer relationships still remain your responsibility.
The jargon - recourse and non-recourse and more
- Recourse - if an invoice is not paid within an agreed period (for example 90 days), it is sent back (or recoursed) to the business who must repay the advance.
- Recourse facility - a lending agreement in which invoices can be recoursed.
- Non-recourse facility - where invoices cannot be recoursed. The lender is covered by credit insurance and cannot sell the invoice back to the originating company. This covers the lender against bad debt and reduces the risk they assume.
- Refactoring fee - a cost incurred when an invoice is recoursed back by the factor.
- Disbursements - additional costs charged by the factor. For example, for admin errors, printing, credit checks, etc.
- Spot factoring - A type of arrangement where individual unpaid invoices can be sold instead of the whole ledger.
- Forfaiting - Similar to factoring but used in trade finance. This is where an exporter’s receivables ledger is purchased, and the debt is collected from importers. This not only assists cash flow but helps with the inherent risks in international trade.