A steady flow of cash is essential for business success. Cash is necessary for covering employee wages and paying rent as well as for settling suppliers' bills. However, most business owners would agree that guaranteeing regular cash flow is one of the most difficult things to accomplish, particularly when trying to get a new enterprise off the ground. This is where invoice factoring can be of great way of financing for a business.
How does invoice factoring work?
In basic terms, invoice factoring is when a business sells its outstanding invoices, or accounts receivable, to a third-party factoring company. The factoring company will make an initial payment to the business which covers a large part of the value of the invoice. Depending on the company, this can be up to 90% of the total amount. The factoring company will then pursue the customer for payment of the invoice in full. They will then pay the remainder of the invoice amount to the business after subtracting their own fee.
Invoice factoring is, therefore, a method of passing on the burden of pursuing a customer for payment to a third party while ensuring the continuation of cash flow in the short term. However, in taking on this responsibility, the factoring company is essentially purchasing a debt by temporarily providing the business with credit to the value of the invoice. In other words, until the invoice has been paid, the factoring company is loaning the business money. As with all forms of loan, there are a range of eligibility criteria that must be met, which will vary depending on the company.
Types of invoice factoring
There are two main types of invoice factoring: recourse factoring and non-recourse factoring. Recourse factoring means that should the factoring company be unsuccessful in recouping the value of the invoice payment from the customer, usually within a pre-agreed time period, the responsibility for paying the invoice will return to the business. In other words, they will have to pay back the money loaned to them by the factoring company including their fee. Non-recourse factoring means that if the factoring company is unsuccessful in obtaining payment of the invoice, then they absorb the debt on behalf of the business. This type of agreement is uncommon due to the risks involved for the factoring company and is usually subject to stringent criteria as well as high fees.
What are the advantages of invoice factoring?
- Improve cash flowThe main benefit of using a factoring company is that the bulk of the value of each invoice is immediately available to the business in cash as soon as the goods or services have been provided.
- Save valuable timePursuing an unpaid bill comes at a cost in more ways than one. Offloading the burden of chasing payment onto a dedicated factoring company frees up valuable time and resources as well as reducing unnecessary stress.
- Alternative to traditional loans or overdraftsFor those businesses who do not wish to take out bank loans or extend their existing overdrafts indefinitely, invoice factoring is a secure alternative with a fixed end-date.
What are the drawbacks of invoice factoring?
- Can affect credit ratingInvoice factoring is still a form of loan agreement and therefore is subject to the same conditions as traditional loans including a lower credit rating and reduced overall access to other forms of credit.
- Variable costDepending on the fee charged by the factoring company and the total amount of the invoice, the cost to a business even on a one-off basis can be significant and not without risk, especially if there is no bad debt protection offered and the customer defaults on payment.
- Risk of reputational damageThe use of a third-party to recover payment can often be considered to be heavy-handed by some customers and may affect the likelihood of repeat business in some circumstances.
How much does it cost?
The cost of invoice factoring will vary depending on the factoring company you choose and the amount of the outstanding invoices they will recover. On average, the fee charged by a factoring company usually ranges between 1-5%. Some companies offer a fixed service charge rather than a percentage of the overall invoice, while others will offer additional services such as bad debt protection in the event a customer defaults on payment. A business should consider carefully how much they can afford to spend with a factoring company to ensure such an agreement is beneficial in the long term as well as in the short term.
Is it regulated in the UK?
Any factoring company registered in the United Kingdom is subject to regulation by the Financial Conduct Authority (FCA) as well as UK Finance (formerly the Asset Based Finance Association). The FCA is an independent body which regulates the financial services industry in the UK, setting industry standards and offering an avenue for recourse and complaints.
Who are the best factoring companies in the UK?
Each factoring company has its own individual selling points which will appeal to different businesses in different ways. The list of members on the UK Finance website is an excellent place to start when seeking a reputable company and is a way to compare the particular services offered by each. Current members include:
- AIB Commercial Finance Ltd
- Barclays Trade and Working Capital UK & Ireland
- Bibby Financial Services Ltd
- Hitachi Capital Invoice Finance
- Investec Capital Solutions
- Santander Invoice Finance
- Skipton Business Finance Ltd