Factoring is normally a long-term arrangement. It is not just for Christmas. Just as it is wrong to buy a puppy on a whim, so it is foolish from a business point of view, to plunge into the world of factoring without fully understanding the implications of factoring.
Thus, before a factoring company will accept a new client it will undertake a survey of its prospective client’s business. The survey will look at five key areas of interest:
- The quality of debts and debtors. The factoring company will look at the transactions a company is seeking to cover by factoring. It will assess the risks of non-payment of invoices. In the case of non-recourse factoring this will also involve a decision of how much to charge in relation to the risk of a factoring company being left with an overdue payment or non-payment of an invoice.
- Administration function. A factoring firm will effectively buy unpaid invoices and take control of the trade receivables ledger. A fee for the administration of this function needs to be determined.
- Continued Profitability. A factoring firm will only consider taking on a client that can show a proven track record for profitability. It is an assessment of the strength of the company in the long-term.
- Ownership of Unpaid Invoices. A factoring firm must be certain that it can buy unpaid invoices that are free from charges or other legal encumbrances such as claims by a third party.
- Ability to Collect Debts. A factoring company will assess the risks involved in buying unpaid invoices in the context of potential disputes over deliveries, returns and cross-claims by other debtors.
It is only after a thorough survey of a business has been made that a factoring company can determine its funding limits for its prospective client. This is an important consideration: a factoring firm might not be able to offer the sums of cash required by the company hoping to enter a factoring arrangement.
Being Investigated by the Factoring Company
Further to the survey, a factoring company will make independent enquiries about its potential new client. It will make requests at Company House to determine the capital and the constitution of a company, and if there are any charges against company property. It will also investigate the shareholders and executives of a company and determine if they have been involved in court proceedings related to business practices. If a company is relatively new, the factoring firm will do independent enquiries into the previous business activities of the directors and shareholders. The results of these enquiries will become the substance of an internal report called a ‘New Business Report’ that the factoring company’s credit committee will scrutinise to determine whether a client is suitable for its factoring services.
The Financial Conduct Authority
The Financial Conduct Authority (FCA) is the regulator for the financial industry. It enforces laws including Money Laundering Regulations 2007. A factoring firm has a legal duty to perform due diligence on companies, shareholders and those who receive significant benefits from a company. For UK companies this is easy to determine; it is much harder for companies registered overseas. Also, companies owned by private trusts and shell companies have to be investigated to unearth who collects on a company’s profits. This is to ensure the factoring company does not end up unwittingly funding illegal activities such as money laundering.
Even after a factoring facility has been agreed and set up, a factoring firm will continue to monitor the situation to look for red flags that point to money laundering and other illegal practices. If any red flags do appear the factoring company will report the details to the National Crime Agency.
A factoring firm will also turn its attention to the goods or services offered by the company applying for factoring services. If the product is of high quality and can only be supplied by a limited number of other companies then it is likely that fewer issues will arise when an invoice is due for payment. Companies who sell products that are widely available or require extensive checks before they are accepted are more likely to have difficulties getting invoices paid. Thus, an examination of the product of a company seeking factoring becomes part of the risk assessment and determines suitability for factoring as well as the fees for factoring.
Terms and Conditions
Every business-to-business transaction is subject to terms and conditions of sale or service. This is another legal layer that a factoring firm must consider before taking on a new customer. If the terms allow for sale or return or allow for sale or exchange then the final sum for the invoice remains unfixed and thus problematic for factoring. In some cases, the selling company will have to accept the buyer’s terms and conditions. These need to be examined for any complications that might hinder or impede the payment of an invoice.
In certain specific types of transactions factoring is not usually suitable:
- Government contracts. Factoring firms will not accept government departments as debtors.
- Debtors closely associated with the seller. Associates, directors and employees closely associated with a company cannot have their invoices from that company factored as they do not offer an independent source for the recovery of a debt.
- Invoices generated by individuals purchasing goods or services for their own use.
If a company sells to another company but also buys from that company there is a problem for a factoring company. This is called cross trading. The problem could be that the debt for an unpaid invoice may be set off against debts that are owed to that company. This is a common issue where the debtor is a regular supplier to the company looking to get prepayment for its invoices through factoring.
A factoring firm will want evidence that a company is meticulous in its fulfilment of orders, in its logistics and in its drawing up of accurate invoices. Any irregularities may lead to delays in payments for invoices and alterations to invoices that will make prepayment problematic. A factoring company assessing a potential customer will scrutinise the potential customer’s administration practices to determine the risks involved.
More research will be undertaken by a factoring company assessing the viability of setting up a new factoring facility. They will want to look at the longer-term financial health of its prospective client. They will ask to see evidence of the following:
- Completed financial accounts for the last two or three years;
- A breakdown of creditors by age;
- Proof that PAYE, VAT and National Insurance payments have been correctly made;
- Cash flow forecasts; and
- Copies of a company’s bank statements for the last 6 months to see if the company regularly goes overdrawn or if its cheques have bounced.
Scrutiny of Debtors
It is not possible for a factoring firm to run credit checks on hundreds of debtors – it is too costly in terms of money and resources. However, the survey will include an examination of the credit rating of the largest 12 to 20 debtors that a company has. A factoring company wants to assess risk by looking at the quality of debtors a company has. As mentioned, they will do credit checks on larger debtors. They will also look to see if any unpaid invoices have led a company to resorting to using debt collection services and legal services. They will also look at the average time it takes for each debtor to pay.
A factoring firm in buying unpaid invoices at discounted prices has the opportunity of making healthy returns via charges and fees. However, the business model requires debtors to pay up. This is the risk for factoring firms. They set up rigorous screening procedures to minimise this risk.
A factoring firm will not accept a new client until a survey has been completed. This will look at the client’s business dealings, its administrative practices, its owners and shareholders, its product(s), its previous accounts and the quality and spread of its debtors. A company might not dig too deeply into a factoring firm’s record but a factoring firm will want to know as much as possible before it agrees to take on a new client.