Introduction - Factoring and Invoice Discounting - the hidden dangers

Factoring and invoice discounting (ID) products are designed to free up working capital against a company's outstanding book debts. They are mostly used to support growth, fund management buy-outs, or finance recovery.

Factoring and ID providers differ from banks in that they do not "lend" money. Instead, they take a legal assignment over book debts (i.e. buy them) in consideration for which they make available a prepayment facility of up to 85% of their value. This allows companies to access funds quickly - usually within 48 hours of raising invoices - rather than having to wait for their debtors to pay in accordance with agreed credit terms.

Most facilities are "with recourse" (where the company bears the risk of bad debts). "Without recourse" facilities (where the provider takes the risk) are underpinned by insurance policies, adding extra layers of complexity and cost.

The market is very fragmented and there are numerous providers to choose from, many offering a better service than the main banks. Some offer product variations such as international factoring or single invoice discounting, whilst others have interesting niches and will consider propositions that a bank would normally decline.

However, factoring or ID is not suitable for all businesses. This is a complex area but broadly speaking; capital goods, construction, transactions with retention of title issues, or involving stage payments or advance payments, are unlikely to be suitable.

Features of Factoring

As well as providing an agreed prepayment facility, a factoring company will also take over the day to day running of a company's sales ledger. This may involve carrying out credit checks on debtors, sending out statements, telephone credit control, collecting payments and taking legal action if required.

When a company issues an invoice, it sends a copy to the factor who, if they approve the debtor's creditworthiness, will allow the company to draw up to the agreed prepayment percentage of that approved invoice, usually via a computerised link.

All invoices must have a printed assignment clause to inform debtors of the factoring arrangement. Debtors settle invoices by making payments directly to the factor, who then releases the balance of each invoice (less charges) to the company.

Features of Invoice Discounting

ID follows the same principles as factoring, but there are some important differences.

Book debts are still assigned to the invoice discounter, but companies retain day-to-day control of their sales ledger, and the responsibility for credit control. It is essentially "factoring on trust", since debtors are not aware of the ID arrangement.

At pre-agreed intervals, a company will send a list of its outstanding invoices to the invoice discounter, and is able to draw up to the agreed prepayment percentage of approved invoices via a computerised link - again normally within 48 hours.

The company will collect payments from its debtors in the normal way, but must bank them through a trust account so that the invoice discounter can monitor receipt of the funds. As before, the balance (less charges) is released to the company.

Unsurprisingly, the acceptance criteria for ID are stricter than those for factoring, and discounters will usually only support profitable companies, with solid balance sheets.

Pricing - an overview

This is another complex area and is best discussed on a case-by-case basis. In simple terms, there are three main components:

• A Service (administration) Charge - this reflects the time spent in administering the facility, or the work required to manage the sales ledger.
• A Discount (interest) Rate - this is the charge for use of the funds, and is expressed as a margin over the provider's base rate. Like an overdraft, the cost depends on how much is used, and for how long.
• Other ("hidden") fees and costs - there are many different types, and their use varies widely. Some providers routinely quote low service charges and/or discount rates, and rely on other fees and costs to increase their returns.

Examples include - minimum service charges; annual renewal fees; telegraphic transfer charges; minimum facility terms; early payment fees; overdue invoice charges; lengthy cheque clearance times; charges for customer letters. There are many others.

Part of the cost depends on the provider's risk assessment (e.g. the discount rate), which, like the service charge, is negotiable if the right case is presented.

The overall cost also depends on other factors, such as the volume of invoices and credit notes, how long debtors take to pay, and the frequency and means by which the provider remits funds to a company's account.

The devil is often in the detail…

There are other factors to consider and in most cases, they are the most important considerations of all. At best, they will increase costs; at worst, they could seriously impair a company's ability to obtain funding. Again, they are best discussed on a case-by-case basis but the following examples illustrate how problems can easily materialise.

Concentration levels: funding limits can be restricted if one debtor accounts for as little as 20% of the total sales ledger. The threshold varies from provider to provider.

Unapproved invoices: prepayment limits are based on "approved" invoices only, so invoices for debtors with a poor or deteriorating credit rating may be excluded for funding. This can happen quickly, and cash flow can be seriously impaired.

Clawbacks: if outstanding book debts exceed a pre-agreed period (usually three months from either the invoice date, or the end of the month of invoice) a provider might "claw back" part of the advance by restricting funding against new invoices.

Bad debts: with "recourse" facilities there is no bad-debt protection, so companies will have to repay the initial advance to the factor or discounter if a debtor fails to pay.

Retrospective discounts: funding limits will usually be reduced to offset discount arrangements with debtors. The impact of large accounts can be quite severe.

Contras: contra trading, associate company trading, and the issuing of high volumes or values of credit notes can also lead to a reduction in funding limits.

Even though factoring and ID products have become much more popular in recent years, it is clear that the potential for error and confusion is still extremely high.

For this reason, facilities should be negotiated carefully at the outset with at least two different providers, preferably more. Whilst sophisticated buyers of these products can invariably negotiate much more attractive terms, sadly the vast majority of businesses just do not fall into this category.

If you are considering factoring or ID products, or if you are a professional advisor whose clients could benefit from additional support in this vital area, just get in touch with us and we will be delighted to help.