Invoice Factoring – Accessing finances through good credit habits
Invoice Financing is a common way of providing working capital by reducing the delay in suppliers being paid by their customers. Whilst considered a modern phenomenon this method of financing businesses has been around for years – around 4,000 to be precise. In essence, the Bank advances a percentage of the sellers’ invoice and then recovers the advance when the customer pays and charges interest and fees for the facility.
There are two common versions of Invoice Financing – Factoring and Confidential Discounting. There are some principles common to both, and whilst they can seem oppressive by the funder they actually make good business sense.
The first key feature is that you need to know who your customer is. This sounds a bit daft, but you need to be sure you are invoicing the legal entity that is taking delivery of your goods or service. Good practice would suggest that you send every customer an account opening form asking them to confirm the company registration number and the relevant accounts department contact details. Once again, sounds daft, but you need to be sure you are sending the invoices to correct address and you have the details of who to chase for payment. You then need to have a reliable paper trail of Purchase Order, Delivery Note, signed by the customer and Invoice all capable of being linked together. If the unthinkable happens and you have to recover your goods you need to be able to find them and then prove they are actually yours.
Supplying goods and services on credit to a customer is a bit like a bank lending you money – except they take something as security. Setting a credit limit based on financial information for each customer is a sensible next step. You might also want to consider insuring your debtors to protect you against non-payment.
So now we are ready to discount our sales invoices. The basic difference between the two versions is that with Factoring your customer is notified in writing, on the invoice, that the funder is providing you with a facility and that you have assigned the debt to them. The customer will pay the factor. Some of them will also chase your debts if you want them to.
Confidential Invoice Discounting, as the name suggests, is a facility where the client is less likely to know that the invoices are being factored. However, given the fact that the bank writes to them to tell them and will periodically ring them to check balances, the customer will catch on pretty soon. In any event, the choice of which version to go for tends to be one forced on you by the lender. Factoring is very open and, as a consequence, a smaller business with less robust financial controls tend to be given no option. It used to be considered slightly vulgar to need to factor your invoices. With so many people doing it now it has become an accepted part of business life. You choose what is best for you.
The operational part is very similar between the two options. You assign the invoices to the Factor, most commonly through a portal and they send you a percentage advance when you request it. The advance percentage will generally not exceed 85%, with 80% being more common. The Factor will then have some in-house rules about invoice values. Above certain levels, they may want to see copies of Purchase Orders and signed Proof of Delivery. They may also operate a funding limit for non-insured debtors. So assuming all is well, they will advance money against invoices to the agreed levels and then wait for the customer to pay. Your facility will have a funding limit and a period over which the invoices will be funded – often called the recourse period. This will be somewhere between 90 and 120 days. So providing the customer pays within that period all is well and your facility will operate as normal.
There are some events that cause Factor stress. Non-payment within the Recourse Period is one. If this happens they disallow the whole value of the invoice from your availability. Good credit control habits will prevent this from happening. You should also ask the business sense of selling to customers who take 4 months to pay anyway. Factors will also only fund to certain levels without some form of security, which is most commonly insurance. Most Factors have their own Insurance Policies they will sell to you, or you can do it independently. If you go over the limits the Factor will not fund the excess and may look to not fund any of the invoices. Again, this seems harsh but it is common sense. Why extend credit to companies the insurance and banking sectors are saying you should limit your exposure to. It may make sense at the time as it drives up sales, but a bad debt takes away from profit.
Factors also get stressed about credit notes and rebates. If your sector is one where these are commonplace you need to discuss this with the Factor and get them to understand. They will often have a measure that limits the value of credit notes before it triggers a conversation and a potential reduction in funding. From their side, it looks like you are inflating the invoice value to get more cash upfront and then reducing it by issuing a credit note which affects their security.
The final thing to be aware of is something called a concentration – they don’t like to see one large debtor dominating the ledger. They will often look to limit this to 30% of the funding. Once again this makes sense to the company as too much exposure to one customer could be detrimental if they moved their business elsewhere.
There are many other things to consider like seasonality and cost. The funder will want to see forecasts and cashflows to be sure the Factoring model works for you.
The Team at NDM have firsthand experience of factoring having run businesses that have relied upon that type of facility. Whilst we don’t claim to be experts, we can share with your our experiences, good and bad.
We can help you with forecasting and evaluating your options. We may even be able to find you an alternative way of funding your business.