Invoice Factoring, How it Works.
In Laymen's terms
In laymen’s terms Invoice Factoring is the process where a company is pre paid for their sales invoices from an invoice factoring company. This allows a company to increase their working capital and maximise on their cash flow.
Invoice factoring companies make their money by charging a percentage of the amount being factored. For example, lets say a company issues £100 invoice, they may only get £90 from the factoring company with the remaining £10 being the commission for the service.
Invoice factoring companies (called Factors) can work in number of different ways however the basic 2 formats of Factoring are:
1) Running your complete sales ledger
This is where the factor essentially runs your complete sales ledger. Invoices are issued from the factoring company and in the name of the factor company. In turn the factor will also run the credit control and chasing of payments. This is usually done through a computerised system and in the majority of cases is accessed through the internet. When a company wants to issue an invoice they log-on to the system and create the invoice as though they were doing it themselves with their own accounting package.
In this scenario the customer is aware that the supplier is using a factor which has its own set of considerations to a business owner.
2) Invisible factoring
This form of factoring is based on the customer not being aware that the supplier is using a factor. Invoices are created and dispatched by the supplier in the suppliers name. They are then logged with the factor and payment is made promptly on the invoice amount less the factors commission. This form of invisible factoring can be more suited to companies where they feel that if their customers know that they use a factor it would be detrimental to their relationship.
Factoring is usually only offered to businesses that work on a credit basis and tends not to be offered to retailers or companies that work on a cash basis.
Factoring Payments
Factoring payments usually work as a percentage of the invoice amount. Normally full payment for the invoice is not made immediately but a majority percentage is made with a second payment when the invoice is settled.
As a simple example, our fictitious supplier generates an invoice for £100. Of which 85% or £85 is paid by the factor to the supplier within 24 hours of the invoice being generated. Let us say that the fee for the factoring is 10% therefore the final £5 (Total payable to the supplier is £90) is paid when the customer settles the invoice.
Considering late payments.
One of the most critical elements of a factor agreement is the procedure of late payments and outstanding invoices. This is usually negotiated with the factor when the agreement is made and specific guidelines can be placed to govern how, when and to what degree the factor company chases payment. This is important as it can have a substantial effect on a supplier’s relationship with their customer. Suppliers and factors also need to consider the liability for bad debt as a factor agreement can sometimes include an element of bad debt insurance or non-recourse factoring.
Factoring is a not just a simple agreement and usually involves a substantial contract length and considerable notice periods. Also, not everyone is accepted by a factor as they have very stringent checks and calculations to make before an agreement is offered.
Before an invoice factoring agreement is offered the factor will:
- Visit the suppliers premises
- Look at their past trading history
- Look at the type of customers they supply to
- Consider the types of products or services they provide
- Consider their future business plan
Once a factoring company has decided a facility can be granted to a supplier they will then agree a credit limit for the facility. This is essentially the maximum amount of outstanding invoices a supplier can have at any one time. Once the threshold or limit has been reached the supplier can still trade and issue invoices, however they will not be part of the factoring agreement and therefore collection and payment will be the suppliers’ responsibility.
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