One common expression used about factoring is that the relationship between a client and a factoring company is like a marriage; whereas, in a hiring or leasing business finance situation the interaction is more akin to a flirtation. This is because a company will usually use the same factoring company for all its trade receivables finance. In contrast, a company will hire or lease from a variety of different companies.
Below are list of guidelines and considerations for companies thinking to use factoring.
- Factoring should be used to fund cash flow. It shouldn’t be a way of raising funds for capital expenditure. In other words, factoring should be used to facilitate the filling of an order, rather than to fund a company’s expansion.
- Projections are key. A company should create forecasts for cash flow and revenue with and without factoring agreements for 1 to 3 years. This way it can be seen if factoring invoices and the costs involved make financial sense.
- A company with a wide range of debtors, adequate credit insurance, efficient sales accounting and credit control will not normally need to factor its invoices. A better option might be invoice discounting.
- Small businesses with sales volumes less than £7 million might receive poor terms from credit insurers. Factoring firms generally offer better terms. They also offer services like sales accounting and payment collection that credit insurers don’t. Factoring firms also take on the risk of bad debt.
- Choose your factoring firm carefully. Banks that provide factoring services will have larger financial assets. Smaller factoring companies might be more flexible and offer better rates but have a weaker financial standing. If a factoring company takes on an unpaid invoice and remits 70% of the invoice amount to its client but then goes into insolvency, then the remaining 30% (minus fees) could well remain unpaid.
Factoring in the UK.
Currently, there are about 60 factoring companies in the UK. They range from small companies with a turnover of less than £50,000 to large banks. The latter dominate the market place. While many companies seeking factoring services use the factoring firm owned and recommended by their banks, it should be noted that the terms offered vary greatly between factoring firms. In this context, it is important to get a few ‘quotes’ before choosing the best factoring company for your business.
Comparing Quotes
Factoring companies usually discuss their fees in terms of administration charge as a percentage of turnover and finance charge as a percentage of funds used. This masks the fact that some services offered by a factoring company are included in the headline price and some aren’t. For example, it is not clear if recourse factoring will charge extra if the debtor is late in paying. This is often called a ‘refactoring charge’ which is a daily rate for overdue debt.
Moreover, if a factoring company has to expend time and resources chasing a debt, they will add extra charges to their fee for filling out paper work, making payments to third parties etc. This is now the norm with both recourse and non-recourse arrangements.
Discount charges is another thing to check before entering into an agreement with a factoring organisation. The discount charge is sometimes calculated from the date the debt is collected; in other instances, it is calculated from a fixed maturity date. The difference between these two positions used to be more apparent when money transfers were delayed by waiting for cheques to clear. Now, with instant bank transfers this is less of an issue.
Changing the Agreement
It is common practice for the standard agreement that factoring companies use to contain clauses which allow for the factoring company to unilaterally change the terms of the agreement. There are several scenarios when this could happen. One of these scenarios being that the money being asked of the factor exceeds their credit limit. The best proviso against unilateral change of the agreement by the factor is to have a clause stipulating that the factor must give a notice period before changes occur. This allows the client to adjust in a timely manner to change.
Terminating a Factoring Arrangement
Termination of a relationship with a factoring company can be problematic. They sometimes insist on a 12-month notice period before termination can be finalised. During this year period prepayments may be reduced which could have a negative impact on a client’s cash flow. A reputable factoring company should be confident in its ability to assess debt risk and collect debt, and not have such draconian clauses in its contract with clients.
More Pitfalls
If a client regularly uses a factoring firm, then it might apply for prepayment as soon as a delivery is made and before a copy of the invoice has been sent to the factoring company. In a good relationship this should not be a problem, but if the agreement contains clauses that prevent this practice, then payment can be delayed to the detriment of cash flow.
Some factoring agreements allow for the factoring firm to change credit limits depending on how often a debtor overruns the maturity date of an invoice. If this happens frequently a factoring company may reduce prepayment credit. Conversely, trusted and long-standing customers might get more generous terms.
As you would expect, the crucial wording in a legal agreement with a factoring company is to do with late payment of invoices, legal recourse and the actions taken if the debtor goes bankrupt. This is detail where the devil lurks.
Finally, there is the issue of the termination of an agreement with a factoring firm. The standard clause used in this scenario stipulates that the client shall repurchase all debts previously purchased by the factor that have not yet been paid by the debtor.
From the Factor’s Perspective
Before a factoring company takes on a new client, they will run a thorough review of the client’s business. This is called a survey. It is used to investigate the following:
- The quality of the debtor and the debt. In other words, what is the risk of a default on payment? If non-recourse factoring is sought then the survey will inform the level of fees levied depending on the risk to the factor.
- An assessment of the administration required by the client and thus, the fees charged.
- To decide on the strength of the client’s business and thus to decide on the profitability of offering factoring services to a client company.
- To make sure that invoices that have ownership transferred to the factoring company does not have any other prior legal claims on them from a third party.
- To decide on the likelihood of hold ups to invoice payment caused by disputes, returns and claims by other debtors.
The temptation for new factoring companies is to fast track the survey and quickly agree terms with a new client. This is risky for both parties involved.
In Summary
There are many key factors to consider when choosing a factoring company. And indeed, a factoring company which is putting up the cash for an unpaid invoice should carefully consider who its clients are.
The legal agreement between a factor and its client is complex. Both parties should scrutinise the small print. They should also do their homework on each other, to make sure they are a good fit.
In a way, a factor-client relationship is like a marriage – it is meant to last, and deepen over time. However, as with a marriage, the fundamentals must be right to begin with if the relationship has any chance of surviving in the long run.
