Also known as invoice factoring, it’s a way for businesses to bring in the money they are owed before their customers have paid it. To do this a debt factoring company buys one or more invoices, paying the business for them but charging for the service.
Here we take a look at the ins and outs of the process and consider some debt factoring advantages and disadvantages.
How does it work?
There’s no single debt factoring definition since agreements vary depending on the position of the company involved. However, there are some common themes.
It’s often used by smaller companies or startups that don’t have lots of cash reserves and need a quick injection of funds, but do have a reliable and regular income. There are clear benefits if you need to invest quickly in your company, repair equipment or pay staff, and don’t want the hassle and cost of chasing payments. Finance companies from high street banks to specialist lenders offer debt factoring services, the best place to start is by comparing prices online.
You can use a debt factoring service for one off outstanding invoices, selected invoices or all your ongoing invoices to provide a consistent cash flow. The option you choose will depend on your financial situation. In most cases, you will invoice your customer and they will be asked to pay into your factoring account.
Once you’ve entered into an arrangement you will be paid an agreed percentage of the invoice total. When your customer has paid the invoice to the debt factoring company, they will send you the remaining amount minus their fee.
For example if you sell them a £10,000 invoice, they may forward you 80% straight away so you get £8,000 immediately. The remaining £2,000 will arrive when your customer has paid the invoice, which depends on the terms of payment on that invoice (within 30 days for example). The debt factoring company will subtract their fee (sometimes known as a discount rate) from that. So if it’s 3% you will receive £1,700 since the discount rate is £300.
Debt factoring charging
What you pay for the service depends on a range of factors, such as:
- The amount you’ll be factoring. The higher the volume and value of invoices you put through a factoring company the lower the fees will be.
- Payment terms. If they have to wait 120 days for payment from your customers, rather than 30, their fee is likely to be higher.
- Your business. Just as they would for a loan, a bank will assess the health of your business. They may require a minimum turnover and for you to have been trading a certain amount of time. They’ll also look at the industry you operate in, how volatile it is and whether it provides a steady income or one that goes up and down.
Fees usually range from 0.5% to 5%, although you may be offered a flat cost. Typically, you’ll be forwarded 80% of the total, although this can vary depending on your agreement and you may be asked to pay a higher fee if you want more money upfront.
You should check what other fees might be involved so you can make a better assessment of the true costs. These can include fees for the initial admin of opening an account, late paying customers, transferring you money, credit checks, renewing your account, exiting your account and if you do not use an agreed minimum amount.
Consequences of a late payment
Occasionally customers can’t pay the debt factoring company within the agreed payment term of the invoice. If this happens the next steps depend on what kind of arrangement you have with the debt factoring company.
If you have what’s called a non-recourse account it’s the responsibility of the factoring company to chase late payments and absorb the loss if a customer doesn’t pay up.
On the other hand, recourse accounts leave you responsible for late paying customers, some companies only offer this kind of account. There are a couple of options if the customer doesn’t pay. You can buy back their invoice and chase payment yourself. Or you may be able to swap it for another invoice of similar value.
The type of account you have is likely to impact the fees you pay. A non-recourse account will probably charge more and give you a smaller percentage upfront because of the greater risk involved. It’s important to be sure which kind of account you have so that you can plan how much of the initial payment to spend and how much you should hold back just in case.
Customers and debt factoring companies
When everything goes smoothly your customers will simply pay into a different account than they used to. It’s worth explaining to them exactly what is happening so they aren’t worried about where they’re putting their money, but little changes for them.
But if a customer is struggling to pay an invoice, the debt factoring company can pursue it in the same way as any other company if they’ve agreed to take on responsibility for the debt as described above. In extreme cases that means they can take the customer to court and instruct bailiffs to take possession of goods to cover the value of what’s owed.
Getting in touch with us
If you’re in need of funds quickly, either because you want to invest in your business or you owe one money, selling a home is another option to consider.
If you’d like to chat about our service, get in touch.