There’s a myth in the market that factoring is the financing of last resort and that any business which has to sink this deep is on the brink of failure!
At one time this may have been partly true as banks happily gave overdrafts to anyone who walked through the door with a half decent business idea and a bit of a financial plan. But nowadays, the reality is very different. Invoice discounting and factoring are the primary sources of working capital finance for many businesses in the UK and are often the only way a bank will even consider supporting its SME customers.
Banks now realise that the debtor book is usually a company’s best and most easily realised asset, should anything go wrong. For some considerable time now, they have taken the view that they can lend more with less risk by taking control over their customer’s debtors in one way or another. So now that debt factoring has become acceptable – even the norm, rather than the exception – it has become crucial that businesses looking at working capital finance should shop around for the factoring arrangement which best suits their particular situation. Factoring is a sophisticated product these days with many different options available. As with all mature markets, choices have grown and that, the obvious solution is not always the best.
So what are the main choices?
Traditional factoring: Here, the factoring company takes ownership of all your debtors – the debtor book. Although the factor will take control of the whole ledger, certain debtors may be reserved (i.e.excluded so far as lending is concerned) usually because they are too old or the sale contract is not considered strong enough or because of a bad experience the factor has had somewhere else.
The factoring company will then make an amount available to the business based on a %age of the unreserved debtors. The percentage is typically from 70% up to 90% depending on the view that is taken of the strength of the ledger and the underlying business. The factoring agreement usually allows the factor to vary this percentage at short notice.
Invoice factoring companies often take over the complete administration as well as ownership of the ledger, including debt collection and credit insurance in which case the client company sacrifices control of its relationship with its customer once the sale has been made.
Factoring contracts are usually for a minimum period of two or three years with penalties for earlier termination
Invoice Discounting: The traditional discount model is very similar to factoring except that the invoice discounter provides a loan to the client – the debtor book acts as security. The amounts available will typically be similar to the debt factoring arrangement.
Generally, in an invoice discounting contract, the client retains control of the ledger and the debtorwill often not even be aware of the arrangement (confidential invoice discounting). The administrative burden on the client is often quite high as the discount company requires detailed monthly reports on the state of the ledger and will usually audit the returns for accuracy. Audits canbe frequent and errors can result in penalties.
Spot Factoring: Spot factoring differs from traditional factoring in that the provider buys single invoices, rather than the whole debtor book. Each transaction stands alone so there is no long term contract and no standing charges. The client has complete discretion as to when he uses the facility. As with traditional factoring, the debtor is always aware of the transaction but there are no reporting requirements so management of the facility is very simple. The Spot factor may take a charge over the rest of the ledger but all aspects of its management (including collections) stay withthe client and the charge is only of relevance for as long as the particular invoice remains unpaid. Spot factoring can be thought of as a “pay-as-you-go” option, used as and when it is needed and with no costs when it is not. Agreements are quick and simple to put in place and there is minimal administration at any point in the transaction.
See Part 2 to discover the key issues to consider in choosing the best solution for your business? Or you can download the full article from our resources section.
