Invoice factoring is a transaction that involves a third party agreeing to buy a business's unpaid invoices at a discount. In such a transaction, the buyer of such invoices gets to manage the sales ledger and collects any money owed to the business by its customers. According to the Asset Based Finance Association (ABFA), the annual turnover from companies that use invoice finance in the UK currently stands at €122 billion. This shows that invoice factoring plays a big role in many businesses' daily operations.
How It Works
In general, for an invoice factoring transaction to happen, there must be a factor, a debtor and an unpaid invoice. The factor is the financial institution that offers or agrees to buy business debt or unpaid invoices. The debtor is the client who owes money to a business in the form of an unpaid invoice. Lastly, the invoice is the document that shows transactions between a business and its clients.
Here is how it works; the business raises an invoice for goods/services sold on credit to another commercial entity and then presents the invoice to the financer/factor for payment (advance payment). Most factors pay off such invoices within 24 hours upon receiving them and the business can receive up to 85% of the unpaid invoice amount. Then, the factor will collect the full invoice amount owed to the business when the invoices become due for payment, deduct its fee and interest, which typically vary from one factor to another, and then submit the remaining balance to the business. It is important to note that customers that do not pay on time may affect a business's ability to access invoice factoring services.
There are two standard costs that you have to consider, interest and fees. Most financiers calculate interest charges daily and then apply them monthly. Interest rates range anywhere from 1.5% to three percent over the base rate. In general, you should expect to pay the same amount of money that you would have paid to access a bank overdraft. The fees you will pay cover the administrative costs of managing your business's sales ledger and range from 0.5 to three percent of your turnover. Other factors that affect fees that you have to pay include number of customers and number of invoices raised.
For any business, cash flow can make the difference between success and failure. This is where factoring comes in handy because it allows a business to access funds without waiting for customers to pay. With the available funds, a business can buy more stock, extend credit lines to its customers, as well as focus on its core functions instead of chasing debtors.
Another benefit of using corporate finance is it allows a business to reduce its operational expenses. Remember there are administrative expenses associated with collecting debts from your customers. By selling the debts to a factor, you do not have to hire employees to manage your company's debt portfolio.
A business that uses corporate finance also benefits from the expertise provided by firms that provide these services such as professional sales ledger management.
To start with, factoring can limit your business's ability to access funding from other financial institutions because you will not be able to use unpaid debts as security. For a business that does not have other valuable assets that it can use as collateral when applying for a loan, this can be a huge disadvantage.
Secondly, using factoring means you are likely to lose the profits that you make from products or services that you sell to clients. In a competitive environment where profits are thin, this can push a business into bankruptcy. Thirdly, most factors will only buy commercial invoices. This means that businesses that sell to the public may have to look elsewhere for financing.
Fourthly, a factor that deals harshly with your clients may force them to shift their allegiance elsewhere.
Invoice factoring is a business debt help method whereby a financial institution pays a business that sells goods/services on credit to other commercial entities upfront. A business can receive as much as 85% of this funding within 24 hours of submitting its invoices to a factor. In addition, businesses usually receive the remaining 15% minus charges such as fees and interest once customers fully settle outstanding invoice debts. The upside to such an arrangement is it improves a business's cash flow as well as reducing operational costs. The downside is you may lose profits from goods or services that you sell.