Whereas a company will have several hire purchase and leasing arrangements, they will usually only use one factoring company. It is therefore important that a company assesses whether factoring is a suitable financing option, and if yes, then they must make sure that the right factoring deal is secured.
The first thing to note is that factoring services should not be used to fund capital expenditure. The general rule is that unless factoring improves a company’s profitability, then it should not be undertaken. Using factoring to manage debt and keep a business afloat is a poor decision, fraught with risk.
It is usual for a company in the process of deciding whether factoring is the best financing option to prepare two projections for the next one to three years – one with factoring and one without. It has to be determined whether a company can be profitable after absorbing the costs of factoring.
These determinations should not be based on the assumptions that all invoices will be suitable for factoring or that prepayments for invoices should be fully used. Over-reliance on factoring to provide working capital is dangerous as there could be a disputed delivery, damaged goods etc. that reduces the amount of funds available by factoring at any given time.
Ideally a factoring arrangement facilitates higher sales and cheaper prices per unit.
If a company has an even spread of debtors and credit insurance it might not require factoring services. If they have robust credit control systems in place, they might not require a factoring company to take control of their ledger of trade receivables. In such a situation, invoice discounting might be a more suitable option.
Which Factoring Company?
If after serious consideration and analysis a company decides that factoring is the best financing solution, then the next decision to make is which factoring company or bank to use.
The key issue is the credit standing of the factoring company. A company should make enquiries that sufficient funds are in place to deal with delays and insolvent debtors. When an invoice is factored a percentage of the unpaid invoice is prepaid. The remaining balance is only remitted to the seller when the factor collects on the invoice. Essentially, the company has become an unsecured creditor of the factoring company. If the factor becomes insolvent in that time, the balance will be unpaid and address through insurance or legal means will be required.
There are about 60 companies offering factoring services in the UK. They range from small, privately-owned companies that only take on clients with turnovers less than £500,000 a year to banks that can handle multimillion pound trade receivable ledgers.
Despite the numerous available options in the UK, many companies are swayed by their bank to use a factoring facility linked to the bank. There seems to be an unconscious bias prevalent in business to follow the suggestions of their bank for fear of opprobrium. Instead, it is worth getting three offers and investigating charges and terms. These can vary greatly from business to business. Not doing due diligence can be costly in this case. Moreover, a factoring firm will take over the sales ledger of a company, placing itself at the heart of a company. Considering this, it is worth spending the time to get the factoring deal that is most advantageous for a company.
Another thing to bear in mind for a company looking to use a factoring firm is membership of UK Finance. It is a trade organisation formed in 2017. It represents about 300 companies involved in the financial services sector. UK Finance makes its members adhere to a code of conduct as well as running seminars and training programmes to maintain high standards in the industry. A company can make an application to a Professional Standards Council if its member is accused of falling short in its services. This provides a company with some reassurance when deciding to opt for a factoring company.
There are two main charges made in factoring. The first is an administration charge derived as a percentage of the annual turnover. The other is a finance charge based on a percentage of the funds used. There are, however, other charges to watch out for. Many factoring companies will charge a refactoring charge for late payment by the debtor. Small companies might also be asked to pay an annual administration charge that could be detrimental to the financial health of the small company. A company must be clear what the administration fee covers as there are often other ancillary charges for actions such as filling documents, inspecting books, increasing debt limits etc.
Within an agreement for factoring, there will be clauses laying out the procedures for terminating the arrangement. These should be scrutinised. Designated periods of notice can be up to 12 months. In some instances, a factoring company will require 12 months’ notice during which time no invoices can be financed. Such conditions could be financially disastrous for a company. Alternatively, a factoring company may include a contractual clause which reduces prepayments during the termination process of a factoring arrangement.
Guarantees and Indemnities
If the company seeking factoring facilities is a member of a group of companies, a factoring firm may insist on legal guarantees made by large shareholders and directors that they will reimburse any losses to the factoring firm if a debt cannot be collected because of insolvency. Sometimes there aren’t any limits placed on these guarantees. Such clauses should be entered in to with extreme caution especially by those individuals risking their own money.
Indemnities are sometimes expected against a company collecting a debt directly rather than allowing the factoring firm to channel money through its own accounts. Indemnity is sometimes sought against deliveries of goods or services that don’t match the details of the invoice.
A company looking to use the services of a factoring firm has plenty of choice in the UK. Before entering any agreement, a company should do its homework regarding fees, guarantees, indemnities and termination clauses.
Moreover, a company should not be unduly swayed by its bank when choosing a factoring facility. A company should consider the size of a factoring house and whether they have the resources to deal with large debts. It is not impossible for a factoring firm to go insolvent and leave its clients short of pocket.
Perhaps the best place to start when choosing the factoring firm that is right for your company is to approach UK Finance. They can advise about industry standards and identify key components of a factoring arrangement that might have otherwise gone unnoticed.