Invoice finance can be divided into two categories: factoring and invoice discounting.
Factoring Overview
A factoring company will purchase a company’s accounts receivable ledger and will provide for each invoice on the ledger that is approved. The invoice financier will become responsible for the ledger. It is their job to chase up debtors and allocate payments received against outstanding balances.
The value that the invoice financier brings to the table is his or her experience in debt management. This is not usually an expertise offered with a bank loan.
Here is a step by step look at the process of factoring:
- A company sells goods or services to one of their customers. This customer is sent an invoice by the company. The customer is the debtor. On the invoice will be a notice of assignment. This is to notify the debtor that an invoice financier is involved in the debt management.
- The company sells the invoice to the invoice financier.
- The invoice financier pays some of the money due from the invoice to the company.
- When the invoice reaches payment date the debtor will send payment to the invoice financier.
- The invoice financier, once he or she has removed fees, sends the balance to the company.
Different Types of Factoring Products
There are 5 types of factoring products. They are described below.
1.Recourse Factoring
Recourse is a legal term and it means the right to demand payment. In recourse factoring if the debtor does not pay their debt after the time delay specified on the invoice, then the factoring company has the legal right to reclaim the money it sent to the company as a result of entering into a factoring agreement for that specific unpaid invoice. With recourse factoring the invoice financier is protected against unpaid debt. Although they have expertise in assessing unpaid invoices and chasing down debt, invoice financiers avoid being out of pocket if a debtor suddenly goes bankrupt. Recourse factoring while still involving a ‘true sale’ is regarded differently in some jurisdictions because the financial risk remains with the seller.
2. Non-Recourse Factoring
This is the opposite of recourse factoring. With this product the invoice financier does not have the legal right to recall payment if the debtor does not pay. The financial risk caused by a failure to pay off an invoice is with the invoice financier in this type of factoring product.
3 Client Handles Own Credit Control (CHOCC)
In this type of factoring arrangement, it is the company who enters into a factoring agreement who manages the credit controls. Whereas, in recourse factoring and non-recourse factoring it is the invoice financier who manages the debt from the unpaid invoices. In this situation a company deals directly with its customer to facilitate the payment of invoices.
4. Export Factoring
For a British company, export factoring is used if their customer is outside the UK. This product will use an affiliate to do the credit control. This affiliate will be a factoring company in the same country as the customer. They will have local expertise in chasing down debts. Once the affiliate invoice financier has secured payment from the customer, it will send the money to the UK-based invoice financier who then takes his or her fees and remits the balance to the British company.
5.Service Only Factoring
This is a factoring product for companies that do not require funding. It could be argued that this is not really a factoring product since a company does not get early payments by selling its invoices to an invoice financier. Rather the company hires the invoice financier to provide credit controls. In this arrangement, the invoice financier might offer credit cover for unpaid finances. In other words, the invoice financier, for a fee, will take on the risk of an invoice not being paid.
It can be seen that the different types of factoring products focus mainly on who is financially responsible for failing to secure payment for an unpaid invoice. The other main consideration is who provides credit control. In the case of export factoring the main difference to recourse and non-recourse factoring products is that a second invoice financier is used who has local knowledge.
Invoice Discounting
With invoice discounting a company sells unpaid invoices in bulk to an invoice financier. The company is responsible for collecting on these invoices.
Here is a breakdown of the invoice discounting process:
- A company sells goods or services to customers and sends them invoices.
- The company uses its unpaid invoices as collateral to get a loan from a invoice finance company or bank offering invoice discounting.
- The invoice financier pays some of the money due for the invoices to the company.
- The company collects its money from its customers and places the cash in a joint trust account. This account is set up by the company and the invoice financier. Crucially, it is only the invoice financier that can make withdrawals from the account.
- The invoice financier withdraws the money from the joint trust account, deducts the fee and sends the balance to the company.
Different Types of Invoice Discounting Products
There are three types of invoice discounting products that banks and factoring firms offer. They are:
1.Disclosed Invoice Discounting
In this type of invoice discounting the invoices will hold a notice of assignment so the customer can see that an invoice financier is involved.
2.Confidential Invoice Discounting
As the title suggests, this is the opposite of disclosed invoice discounting. In this instance the invoice does not hold a notice of assignment. The arrangement between the invoice financier and the company is kept confidential.
3.Non-Recourse Invoice Discounting
In this type of invoice discounting if an invoice is not paid by a debtor then it is the invoice financier who absorbs the costs. As mentioned above ‘recourse’ means having the legal right to reclaim money in the case of bad debt. Without the right of recourse the invoice financier cannot reclaim its prepayment if the debtor defaults.
In Summary
Invoice financing can be considered to consist of two categories: factoring and invoice discounting. The one key difference between these two categories is that in factoring the money from the invoices are paid directly into the account of the invoice financier. In invoice discounting the money is paid into a joint trust account. Also, it is the seller that does credit control in invoice discounting.
The term recourse signifies if the invoice financier has the legal right to claim all the money back that he or she forwarded to the company if an invoice cannot be paid. Clearly, a company using non-recourse factoring or non-recourse invoice discounting is better protected against non-payment of its invoices.
Export Factoring allows for companies that have overseas customers to still sell their ledger to an invoice financier in their own country.
The competence of the invoice financier is crucial in both factoring and invoice discounting. Their debt management skills are as important as the funds they provide to a company seeking the early release of money from its generated invoices. So much so, that companies often use invoice financiers to just control debt rather than procure funds against unpaid invoices.
Finally, it should be mentioned that the term ‘invoice financier’ refers to a division of a bank or a factoring company. Factoring and invoice discounting agreements often feature large bundles of invoices. It needs a team to do due diligence on large amounts of invoices. It is common for companies to have arrangements in place to sell future invoices to factoring companies.
