Factoring (or invoice factoring) is a type of short-term business financing where a companies’ 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.
Factoring is often known by various names, including accounts receivable finance, invoice finance or debtor finance. However, technically these terms describe the broader category of which factoring is a specific type. An alternative is invoice discounting, with several key differences, which we’ll outline below.
In this article, we’ll look in detail at the world of factoring, the pros and cons and it’s key differences to invoice discounting.
Factoring comes right out of the pages of history. Whilst the earliest records stretch back 4,000 years to Ancient Mesopotamians, it was the Romans who got things started when they employed the first specialist debt collectors. In fact, the word factoring comes from the latin ‘facere’. In the intervening centuries, it has evolved into the industry we know today.
Recruitment and labour-hire - an example
To give an example, a labour-hire business supplies temporary workers to various firms. The workers remain contracted to the labour-hire company, who pay them weekly based on timesheets they complete. Those timesheets are then invoiced to their clients, however, payment terms of 30-60 days mean they have to wait for the funds.
Having to meet payroll weekly and wait for their debtors to pay creates a cash flow gap. This restricts their ability to cover day to day costs, take on new clients and grow the business. This is where the invoice factoring company comes in. It offers cash up-front by buying the receivables ledger.
How it all works
It typically works like this. Your entire ledger is taken over the factoring company. For each invoice, you get an advance amount of 70-85%. This happens quite quickly, often in 24 hours. The factor then chases up payment. Once a debtor pays the invoice, you get a second payment called a rebate which is the remaining balance, minus their fees. These can 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 usually all invoices are part of the arrangement. They credit check customers, chase payments and deal with them on behalf of the business.
It provides businesses with quick working capital allowing them to pay staff, meet operating costs, expand, meet orders and in many cases, continue trading.
Factoring 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 & labour hire, transport, logistics, wholesale and distribution.
- Credit history of debtors - whilst a factor will look at your creditworthiness, they will also be interested in knowing more about your clients. Since that is whom they will be collecting the funds from.
- Age and concentration of ledger - these are important to determine risk. They’ll look how overdue your invoices are, in order to see how easy collections will be. And how many debtors you have, the fewer the greater the impact should they 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||It is inflexible. Usually involves the full invoice ledger for a long period of time (24 months)|
|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|
|Doesn’t require any fixed assets as collateral||It can have a bad reputation and 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)||There are hidden costs (known as disbursements)|
|Suitable for small business. 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|
What about invoice discounting?
An alternative to invoice factoring is discounting. It is similar. And it offers many of the benefits of factoring. Instant working capital, no fixed asset requirements, relatively quick and easy application process. But it comes with one main difference:
- You stay in control - discounting companies stay in the background. Debtors pay into a bank account they set up for you. Collections and customer relationships 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. This covers the lendee against bad debtors
- 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
- 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. An exporters receivables are purchased and the debt is collected from importers. This not only assists cash flow, but helps with the inherent risks in international trade
The Waddle Difference
Waddle is not factoring. We’ve built an innovative invoice finance solution allowing businesses to close the cash flow gaps that are holding them back. The Waddle platform seamlessly connects with cloud accountancy platforms, like Xero & MYOB and generates a finance offer within a few clicks.
Once approved, Waddle offers an instant line of credit based on your unpaid invoices, which is adjusted in real-time as they are raised and paid. You pick the invoices to fund and only pay for those that you draw down. And thanks to the cloud accounting integration, bookkeeping is a breeze with no invoices to upload and instant reconciliation.
It’s also fully confidential, so your important client relationships stay with you. And Waddle offers the friendliest terms with no minimum monthly spend, no contracts or hidden fees, giving you fast and easy access to working capital with minimal fuss. Get an offer now!