Once a company has decided to use a factoring company to gain early payments on its outstanding invoice, an invoice finance facility is put in place. This post will look at some of the essential mechanics involved in this process to know how factoring works.
The finance facility will set out the terms of the relationship between a company and a factoring company. It will state what type of facility has been deployed, the fees and discount charges. The percentage of prepayment on unpaid invoices available and other relevant terms and conditions.
The process all starts with the company’s sales ledger. This will be constantly updated as invoices are paid and sales are moved from the debit to the credit sections. An invoice financier buys debt from a company so he or she is very much focused on assessing the value of this debt. There will be some invoices on the sales ledger that the factoring works firm will not buy or provide prepayment for, these are called ‘retentions’ or ‘unapproved invoices’. The reasons for refusing invoice finance for some invoices are as follows:
- Debtor balance in excess of credit limit. A company will often take out a credit insurance policy to run alongside the factoring works facility. This policy will set a limit to how much will be paid back to the company if the debtor defaults. An invoice financier will not approve invoices for factoring larger than this credit limit.
- Debtor balance in excess of funding limit. A factoring agreement will set limits on the sums of money it is prepared to prepay for any one debtor. An invoice financier is very reluctant to put all their eggs in one basket.
- Debtor balance in excess of concentration percentage. This is similar to point 2. The invoice finance facility will be structured so that there are limits on what percentage of money prepaid can be spent for any one debtor.
- Invoices exceed the recourse period. Simply put, this is the time limit placed on the invoice terms of payment. Factoring firms are happy to approve invoices due to mature in 60 days. They are less happy to wait 6 months for a debtor to pay. Statistically, the longer a debtor has to pay an invoice the more chance there is of a default on the invoice payment. Thus, the invoice financier will not approve invoices for prepayment that exceed their set limit on how long they will wait for the debtor to pay.
- Debtor disputes. If a debtor queries an invoice because the goods or services bought were faulty or incorrect, factoring will be unavailable until the issue is resolved.
- Contra trading. This refers to when a company not only sells to another company but also buys from the same company. Factoring firms are reluctant to buy invoices where the debtor might reduce payment because it is owed money from the seller. If an invoice is prepaid from a company involved in contra trading then usually a retention will be placed on paying more than the difference between what the two companies owe each other.
- Bad debtors or discounts. An invoice financier will look carefully at the reputation of who holds debt. The payment of some debts is too doubtful for the risk to be taken of providing factoring. Also, if a company offers discounts, such as early payment discounts, then those invoices affected by such discounts will be unavailable for factoring
Some Examples of How These Rules of Factoring Works
Exceeding a concentration percentage will lead to an invoice being unavailable for factoring. A factoring facility will place a retention on debtors owing more than 25% of the total sales ledger. Thus, if the total of the sales ledger is £100,000, and one debtor owes £25,000, then until that amount is paid down no further funds will be available for factoring invoices sent to that company in question.
A debtor has a funding limit of £30,000 but owes £45,000. Thus, a factoring firm will calculate the difference – in this case £15,000 – and will place a retention on factoring any more invoices from this debtor until the debt falls to below £30,000.
An invoice financier will look at the value of the total sales ledger and make deductions for invoices that have exceeded the recourse period (amount of time allowed for an invoice to be paid) and for invoices that are disputed. So, if a company has a sales ledger totalling £200,000, and has invoices worth £10,000 that have exceeded their recourse period and £15,000 worth of invoices that are disputed then the total approved ledger will be £200,000 minus £25,000 (10,000 + 15,000). That equals £175,000.
As the total of the approved sales ledger is constantly changing, so the size of prepayments available for unpaid invoices will alter. If a debtor has a funding limit of 25% of the sales ledger. Then the maximum amount of money available to prepay invoices from that debtor will fluctuate in relation to the approved sales ledger. Thus, if a debtor owes £25,000 when the approved sales ledger was £100,000. But the sales ledger rises to £200,000. Then the factoring facility will allow for the debt to raise to £50,000.
A company has a total approved sales ledger worth £150,000. The factoring facility will stipulate what percentage of that sales ledger is available for prepayment. If it is 80%, then the company is able to get £120,000 from the factoring facility.
As Time Goes By
As can be gathered from the above examples, factoring does not usually involve one off invoices from customers. Rather, the invoice financier will repeatedly manage prepayment for its client’s invoices within defined guidelines. A relationship of trust is needed. The invoice financier has to continually monitor that all invoices in the approved sales ledger are genuine. This is done by debt verification checks. If fake invoices are discovered then the relationship will be damaged.
Debt verification involves a company providing evidence that a delivery has been signed for on delivery and that the delivery meets the terms of the contract. A factoring firm will often contact the debtor to check they are happy with a delivery and that the ensuing invoice is acceptable for payment.
Another aspect of the relationship between a company and its invoice financier is keeping each other up-to-date on the state of funds available. It is best if a company is notified if one of its customers is approaching its funding limit or concentration limit. Knowing the state of play allows a company to avoid issuing large invoices that are ineligible for factoring.
Amounts that a factoring facility will not approve are called ‘retentions’ or ‘unapproved’. These are calculated based on rules regarding debt age, funding limits, concentration limits and disputes. Contra trading also involves retentions to take account of a situation where a company is both owed money by and owes money to the same customer.
Availability is calculated as a percentage of the total approved sales ledger. The latter refers to the total amount of debts that the factoring firm is willing to recover. This is determined by taking the sales ledger and subtracting the sum of the retentions.
To avoid disputes between an invoice financier and a company a close working relationship needs to be established. An invoice financier can keep a company in good financial health. But can also cause serious headaches if he or she suddenly withdraws funding because one of the factoring agreements criteria has not been met.