FACTORING AND DISCOUNTING

INVOICE FINANCE 

Factoring and Invoice Discounting are two separate forms of finance, although the word ‘Factoring’ is often used to describe both because it has existed for longer. A more precise generic term is Invoice Finance, which covers both products and their variants. 

FACTORING

What is factoring?
Factoring is a form of increasing working capital for businesses and also a credit management service. Businesses, which sell to other businesses on normal trade credit terms, have to wait at least a month (sometimes more than three) between raising an invoice and the customer paying. Often, the total amount of all these unpaid invoices represents the greatest asset in the business. The business therefore has a huge amount of working capital simply tied up in these unpaid invoices.

Factoring helps this situation in two ways:
1) The business sends a copy of the invoice to the factoring company who then manages the whole process of sending out statements and chasing customers to pay when the invoice falls due. This credit management service, undertaken by experts, will invariably lead to the cash coming in quicker and of course lets the business concentrate on its core activity.

2) The factoring company will make available a large proportion of the invoice value (normally between 80-90 per cent) immediately after the invoice has been raised. The business receives the remaining value (between 10-20 per cent), less charges, when the customer pays the invoice. So, a factoring company will release the amount of working capital into the business by making between 80-90 per cent available immediately.

What are the different types of factoring?
Recourse Factoring: The factor assumes responsibility for a client business' credit management, but does not provide credit protection. Unless the client business has bought separate credit insurance, it will be responsible for any bad debts from its customers.
Non-Recourse Factoring: The factor will provide a client business with full credit cover against any bad debts, up to agreed credit limits set by the factor for each of its customers.

What types of businesses use factoring?
Factoring is used by around 18,000 businesses in the UK, mainly for their domestic sales but also for exports to the major trading nations. A typical business using a factoring facility would be selling to other businesses and have an annual turnover of between £250,000 - £5,000,000.

What costs are involved with factoring?
There is a fee for the service, which is calculated as a percentage of each invoice. Typically this fee will be between 0.5-3.5 per cent of the turnover, depending on the amount of work involved. The other charge is that for the cost of the funds used and is calculated like an overdraft - as a percentage over base rate. Typically the rate for the funds used varies between 2-4 per cent over base.

Added Security - Credit Protection
Additionally, some factoring companies will provide credit protection against the risk of the client’s customer going out of business. This type of facility is called “non-recourse” within the industry. An individual limit is then set for each customer, and the factoring company will cover any loss within these limits. There is an extra charge for this service, usually around 0.5 per cent of the turnover, but this will depend of course on the credit worthiness of each customer.

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INVOICE DISCOUNTING

Invoice discounting, like factoring, releases the cash tied up in unpaid invoices. It makes available 80-90 per cent of the invoice value as soon as it has been raised and the remainder is passed over when the customer pays.

Unlike factoring, the business retains control of the credit management function and in most cases the client’s customers are unaware of the invoice discounting arrangement. This confidentiality makes it more popular amongst more established and sophisticated businesses. Consequently, the average size of a business using invoice discounting is higher than those using factoring and is usually between £1million and £25million annual sales.

What types of businesses use invoice discounting?
Invoice discounting is used by around 10,000 businesses in the UK with a combined turnover exceeding £70billion in 2001. The growth rate of companies using this form of working capital finance is over 12 per cent compared with the previous year.

What costs are involved with invoice discounting?
The fee structure is similar although the charge on turnover is considerably smaller because a credit management service is not provided. The cost of funds is also likely to be lower, reflecting the stronger financial standing of the business being funded.

THE INVOICE FINANCE MARKET

The largest Invoice Finance companies are owned by the big four UK clearing banks and the majority are owned by other UK, European or American banks. However, there are some independent companies and the whole market is now very competitive. The intense competition has been maintained because of the tremendous growth in factoring and invoice discounting but it has still meant that pricing is keen and a growing business requiring a facility will find many welcome offers.

The growth in the market has seen many foreign owned players move into this sector during the last 5 to 10 years. At the top end, some are offering complex structured packages with invoice finance at the core but utilising as many of the other assets in the business as they can. However, traditional factoring for the smaller, newer companies is still very popular.

Most Invoice Finance companies have an on-line capability, which enables clients to send invoices and other documents electronically and for them to draw down cash, subject to it being available, on-line. The industry is becoming more and more sophisticated in this area particularly as each innovation gives them a competitive edge.

HELPING THE DECISION MAKING PROCESS

For businesses looking at different funding options available, the following basic but essential tips should be followed:
1. Make sure the financier knows your business and business needs.
2. Consider taking professional advice before entering the relationship with the service provider.
3. Ensure you are comfortable with the personnel dealing with your account.
4. Be confident in the financial stability of the potential service provider.
5. Give consideration to whether the organisation is a member of the Factors and Discounting Association

For more information about invoice finance, please visit the FDA’s website, www.factors.org.uk.

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