What Is Invoice Factoring?
Invoice Factoring

Factoring is the older and more hands-on form of invoice finance. Instead of simply lending against your invoices, the factor effectively takes over your sales ledger: it advances cash when you invoice, chases your customers for payment, and settles with you when they pay. For a small business without the time or staff for credit control, that combination of early cash and outsourced collection is the attraction. The cost, and the fact that your customers deal with the factor, are the trade-offs.

How factoring works, step by step

1. You deliver goods or services and invoice your customer, with instructions to pay the factor.
2. You send a copy of the invoice to the factor.
3. The factor advances an agreed share of the invoice value, often within a day or two.
4. The factor manages collection: statements, reminders and calls to your customer.
5. Your customer pays the factor.
6. The factor pays you the balance, less its service fee and discount charge.

Factoring and invoice discounting

For the wider picture, including costs and when finance makes sense at all, see invoice finance.

Recourse and non-recourse factoring

Under recourse factoring, if a customer does not pay within an agreed period, the factor recovers the advance from you. Under non-recourse factoring, the factor bears some or all of the loss if an approved customer becomes insolvent, usually within credit limits it sets for each customer, and charges more for the protection. Non-recourse does not usually cover a customer refusing to pay because of a dispute about your goods or work, so clear contracts and delivery evidence still matter.

What factoring costs

Charges usually combine a service fee, often a percentage of the invoices factored, and a discount charge on the money advanced for as long as it is outstanding. There may be set-up fees, minimum monthly fees, fees for credit checks on your customers, and exit fees. Because factoring includes collection, its fees are typically higher than invoice discounting's. Compare the total cost on a realistic year of your invoices.

What the factor will look at

A factor is lending against your customers' promises to pay, so it looks at your customers as closely as at you. Expect it to check:

• Who your customers are. Established businesses and public bodies are easier to fund than new or small ones. Most factors will not fund invoices to households.
• How concentrated your sales are. If one customer accounts for most of your invoices, the factor may set a lower limit for that customer.
• Your invoicing and delivery evidence. Clear purchase orders, delivery notes and signed-off work reduce the risk of disputes, which are the main reason factored invoices go unpaid.
• Your payment history. How long your customers take to pay now, and how many invoices end up disputed or credited.
• Existing security. A bank or other lender may already hold a charge over your debts, which has to be dealt with first.

Questions to ask before you sign

Read the agreement itself, not just the proposal. The advance rate, fees and notice periods that apply are the ones in the signed contract.

Leaving a factoring agreement

Factoring agreements usually run for a minimum period with a notice period after it. When you leave, the factor has already advanced money against invoices your customers have not yet paid, so the facility has to be settled: you repay the outstanding advances, often out of the customer payments as they arrive, or a new funder takes over the ledger. Plan the exit before you enter, including the fees, and tell your customers again when payment details change back.

Factoring compared with other ways to fund your invoices

Can a customer's contract stop you factoring?

Some larger customers write clauses into their terms that forbid you from assigning or selling the debts they owe you. For contracts entered into on or after 31 December 2018, the Business Contract Terms (Assignment of Receivables) Regulations 2018 generally make such clauses ineffective where the supplier is a small or medium-sized business, so the clause cannot stop you factoring the invoice. There are exceptions, for example for some financial services contracts and where the supplier is a large enterprise or a special purpose vehicle, so check the rules if a customer points to a ban clause.

Is factoring right for your business?

Factoring tends to suit businesses that:

• invoice other businesses, not households, on 30 to 90-day terms
• are growing, so each month's sales tie up more cash
• have creditworthy customers the factor will accept
• lack the time or staff to chase payments themselves

It is less suitable where invoices are small and few, where customers are households, where disputes about work are common, or where you would rather customers did not know about the arrangement.

Your customers and the factor

With factoring, the factor becomes the voice your customers hear when an invoice is due. Ask how it chases: how often, in what tone, and how it handles a customer who is a little late but valuable to you. Tell your key customers in advance, so the change of payment details is expected rather than suspicious. Invoice fraud often involves fake changes of bank details, so a customer who is told directly by you is much more likely to trust the new instructions.

Spot factoring

Selective or spot factoring lets you factor individual invoices when you choose, rather than your whole sales ledger. It usually costs more per invoice, but there is no long-term contract or minimum volume, which can suit a small business that only occasionally has a large invoice on long terms.

Factoring and your records

Your sales invoices and the VAT on them are unaffected by factoring: you still account for VAT on your sales in the usual way. How the arrangement appears in your accounts depends on whether you keep the risk of non-payment; many recourse arrangements leave the invoices as your receivables with the advance shown as a liability. The factor's charges are business costs. Ask your accountant how to record the facility before you start.

A worked example

A small cleaning company wins contracts with three office landlords paying on 60-day terms. Its wages are weekly. It signs a recourse factoring agreement: its invoices tell customers to pay the factor, the factor advances 85% within 48 hours, chases payment, and pays the balance less its charges when each landlord pays. The company can meet its weekly wages while the landlords take 60 days, and it no longer spends evenings chasing invoices. The charges, a few percent of each invoice, are the price of both.

Alternatives worth trying first

Before factoring, consider shorter payment terms, deposits, stage payments and a disciplined chasing routine, which cost little or nothing. For business customers who pay late, statutory interest and fixed compensation are available; the late payment interest calculator works them out. The guides on invoice payment terms and how to chase an unpaid invoice cover each.

Common mistakes

• Ignoring the minimum term and exit fees.
• Assuming non-recourse covers disputes.
• Not telling customers, so the new payment details look like fraud.
• Factoring invoices that are likely to be disputed.
• Comparing headline fees instead of total annual cost.

Related terms

Factoring is one form of invoice finance, built on your accounts receivable. If a factored invoice is never paid, the recourse terms decide who bears the loss. For VAT-registered businesses, HMRC's guidance on bad debt relief says relief is not available while a debt remains assigned to a factor, and not at all where the assignment is absolute with no provision for the debt to be reassigned to you. If the agreement lets the factor reassign an unpaid debt back to you, relief can become available once it has been reassigned.