March 12, 2020
Factoring is a short term financing product, where a company sells its outstanding invoices to unlock working capital.
There are 3 parties involved in a typical Factoring arrangement.
1) The Business, or borrower, who has an outstanding invoice, and needs working capital;
2) The Customer, or debtor, who has procured goods and services from the Business ; and
3) The Financier, or Factoring Company.
In Factoring, the Financier buys the invoice issued by the Business to its Customer, and provides an advanced payment. This allows the Business to receive funds in advance, instead of having to wait for the Customer to pay according to the payment terms.
The Advanced payment amount is usually a percentage of the invoice value (known as the Advance Rate), typically 70% to 90%. The Financier is then repaid on the Invoice due date. For this service, the Financier charges a fee, which is typically deducted from the Financier’s payment to the Business.
Although commonly grouped together with loan types, factoring is not strictly considered a loan, as it is simply a form of advanced payment of an invoice, or a sale of a receivable (invoice). For that reason, factored amounts are usually not considered a debt or liability on a company’s balance sheet.
There are different variations of factoring, which will affect the fee as well as the Business’ obligations to the Financier. Not all Financiers offer these services.
In Notified factoring, the Customer will be informed or “Notified” of the arrangement in writing. The Customer will make the invoice payment directly to the Financier on the due date, rather than to the Business. In this arrangement, the financial strength of Customer is important. A larger, more reputable Customer will be viewed favourably by the Financier, who can offer lower fees.
In a Non-Notified factoring transaction, the Customer is unaware of the arrangement and pays the Business as usual. The Business then uses these funds to repay the Financier on the due date. This is considered a “riskier” transaction and Financiers usually impose stricter requirements for Businesses and charge higher fees.
There are 2 variations of Notified Factoring.
In a Non-Recourse factoring transaction, the Business has no repayment obligations if the customer fails to pay the invoice; the Financier takes on the full risk of default and will handle late and defaulted payments.
Non-Recourse factoring is often likened to trade credit insurance for small businesses, as the Business is protected from unpaid invoices, especially in cases where the Customer goes bankrupt.
However, Financiers still can have recourse to the Business in Non-Recourse arrangements, in particular when the Business has not performed according to the sales or service contract e.g. the Business provided malfunctioning equipment.
In Recourse factoring, the Business will be held accountable for any unpaid sums by the Invoice due date. This means that if the Customer defaults on invoice payment and fails to pay the Financier, the financier can claim any owed sums from the Business.
Non-notified factoring is by nature a recourse arrangement, as the Business is always liable for the full advanced sum.
Financiers offering Full Ledger factoring will buy over a Business’s complete set of invoices or account receivables. Often, they will also offer other value-added services including credit control (i.e. reviewing customers and their potential credit risks), and debt/invoice collection.
Spot Factoring (also known as Single Invoice Financing) allows Businesses to pick and choose specific invoices (or even a single one) to finance, rather than the entire sales ledger. This allows SMEs flexibility in planning and balancing their cash flow needs. Spot Factoring is often more expensive per invoice, but Businesses’ stand to save if it isn’t necessary to finance the entire ledger. Spot Factoring is also a good choice if a Business does not want to make its factoring arrangement known to all of their Customers.
Factoring may be a good financing option when a business needs cash urgently, but is not expecting to be paid immediately on their invoices due to pre-agreed payment terms.
Invoice factoring is usually much faster than taking out a business loan, as the money is often transferred to the Business in days without the long and strict checks required by lending institutions. Invoice factoring applications are also approved at much higher rates than term loans.