Factoring is a form of financing for business, where a factoring company agrees to advance you a certain percentage (around 60% – 80%) of each sales invoice you raise. The factoring company then take on the responsibility for the commercial debt recovery from your customer when it falls due. Once this has been done, the factoring company makes available the balance of the invoice amount less the fees the factoring agency takes (usually 2% – 5% of the invoice value).
The process of factoring works in the following way: you deliver goods or services and raise an invoice for them, you sell the invoice to a factoring company. Payment is made as a percentage of the value of the debt, often payment is advanced in instalments, with the first instalment comprising the majority of the value of the purchase, and further fees are charged at the end.
Over other forms of borrowing such as overdrafts or business loans, it has the advantage of not requiring any other form of security in order to advance the loan. Invoice discounting is an alternative to factoring that works in a similar way, except that legal ownership of the debtor book is not transferred to the factoring company.
Are there advantages to factoring?
The principal advantage of factoring is improved short term cashflow for companies that have difficulty, either due to internal issues or trade conditions, with commercial debt recovery from a significant proportion of customers. It is not an ideal solution however as it indicates that a business requiring such general credit control assistance has an underlying significant business problem.
What are the disadvantages of factoring?
Factoring is expensive and should not be the first port of call. Many factoring companies only pay 50 % the value of invoices in a non-recourse factoring arrangement. In recourse factoring arrangements, the factoring company can force its client to buy back debts which the factoring company has not recovered. The obvious risk with this is the impact on cash flow, uncertainty and the lack of incentive for the factoring company to make sustained efforts to collect the underlying debts on it. Should the business want to sell the debt at a later stage, the market value of the debt will have fallen significantly.
In addition, the fact that a company has entered into a factoring arrangement can adversely affect the ability of the business to raise capital by other forms of financing. It can also make commercial debt recovery more difficult as customers will become aware that your business is experiencing cash flow difficulties and delay payment further in the hope you may become insolvent, in which case they will hope to avoid payment at all.