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What is Invoice Finance?


The Pros and Cons of Invoice Factoring and Discounting

Invoice finance is promoted as a way of improving cash flow and working capital for businesses. In this article we look at how invoice finance works and discuss the pros and cons of this solution to cash flow issues.

There are two forms of invoice finance, Invoice Factoring and Invoice Discounting.

Invoice Factoring

Invoice factoring provides a prepayment against your sales ledger. You are effectively selling your unpaid invoices on to a third party, the factoring company (or factor). The ownership of the invoice passes to the factoring company and with it the responsibility to collect the money from your customer, who will be requested to pay directly to the factoring company.

To qualify your business will need to have an annual turnover of at least £100,000 – although some factoring companies will consider working with smaller businesses. The agreed advanced level can be up to 90% of the value of approved invoices with the balance being paid once the invoice has been settled in full.

How it Works

  • You raise your invoices in the normal way, the invoice will show that the debt is being factored and which factoring company your customer needs to pay
  • Invoices are uploaded via an electronic system and once approved by the factor the agreed advance is released and made available usually within 24 hours.
  • The factor will issue monthly statements and be responsible for your credit control procedure and making contact with your customers
  • Your customer then pays the factor directly once the invoice is due and the remaining balance of funds is passed to you.

There are two types of factoring – recourse and non-recourse factoring.

In recourse factoring the factor does not take on the risk of bad debts and non-payment by your customers. The factoring company will reclaim the money they advanced to you if the customer does not pay within a certain time period. Your contract will state how many days after the due date for payment you must refund the advance.

In non-recourse factoring the factor takes on the risk of the bad debt (although if an invoice is disputed the factor will require you to pay the advance back). As a result it is more expensive than recourse factoring. It accepts specific risks around the customer inability to pay but it will not insure against debts that have a genuine dispute. The factor takes over all rights to pursue the customer for payment including the right for legal action

The factor will charge you a service or factoring fee and interest as well. Typical costs for the service fee / agreed factoring fee range from 0.5 – 3% of the total value of the factored invoices Interest is usually charged at 3% above the Bank of England base rate and calculated against the balance of funds drawn. Interest is worked out on a daily basis and charged out monthly – often being taken against your available funds limit.

Invoice Discounting

Invoice discounting works in a similar way to invoice factoring with the difference being that you remain responsible for the collection of the debts – it is therefore a more discreet way of borrowing money as your customers need not know that you have taken financing on your invoices.

The invoice discounting company (or discounter) will charge a monthly fee for the service and interest on the amount borrowed against sales invoices.

Invoice discounting tends to only be available to businesses that sell products or services on credit to other businesses and have an annual turnover of at least £500,000. Again, like factoring the agreed advance level can be up to 90% of approved invoices with the balance being paid once your client has paid the invoice.

The discounter may not lend against invoices to all your customers for example if they have a poor credit rating, special extended credit terms or small value invoices.

Costs are less than for invoice factoring as you are still responsible for collections. Typical charges are 0.2 – 0.5% of your turnover, plus interest costs of around 3% above base rate.

How it Works

  • You notify the discounter of the invoice details electronically via downloads of your sales day book
  • Once they receive this notification they will make funds available at the agreed percentage rate. As and when your clients pay you pass these funds to the discounter thus reducing the outstanding balance and making the remaining percentage available.
  • Your account balance will fluctuate depending on the amount of invoices you assign / download, funds drawn against and cash received. The discounter will recalculate the amount available to your business after every transaction.

Advantages and Disadvantages

Advantages

  • Boost to cash flow
  • The factoring company takes over the task of chasing customers for payment

Disadvantages

  • The factoring company may not treat your customers as you would like when chasing for payment
  • You lose control of how much credit to offer your customers which may affect your competitiveness
  • It's quite an expensive form of finance, with knock on effects on the bottom line
  • Contracts can be long, a minimum 3 months but most factors will often require longer
  • Frequent site visits and audits may be required by the factoring company which can be a disruption to your business
  • You may be liable for bad debts depending on whether you have recourse factoring or non -recourse factoring
  • Invoice financing may affect your ability to get other funding as you will not have your ‘book debts’ available as security, due to the fact the lender has placed a ‘fixed charge’ over them
  • Once a business enters into this kind of arrangement, it can find it very difficult to leave as it has become reliant on the cash flow
  • Some companies do not like dealing with suppliers or customers who are factored as they see them as a risk

Invoice financing is an expensive form of finance and can be difficult to escape once your business has become reliant on releasing cash from invoices on the day they are invoiced. A well-managed credit control function is an alternative approach. Make sure your customers pay you on time, every time and there will be more cash in the bank.

Now you can outsource your credit control, making a strong credit control function an option for businesses of all sizes.


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