A factoring company will undertake a survey of a potential new client and make all the necessary checks to decide if a company’s invoices are suitable for factoring. If a company is approved for factoring services, the fees and charges need to be agreed. This post will look at the costs involved in factoring.
The Discount Charge
The discount charge is determined by the cost of funds to the factoring company (namely, the cost of borrowing money); the attractiveness of the business; and the potential risk and loss of funds from the company going insolvent. This last criterion is determined by an assessment of the company’s financial strength, the quality of its management team and the likelihood of disputes about orders from its debtors. If a company is looking for non-recourse factoring the quality of a company’s debtors becomes particularly important, as the factoring company might be faced with legal bills to force a debtor to pay an invoice that the factoring firm owns.
The Administration Charge
This charge is for the administration of a factoring facility. The administration charge is less if invoice discounting is the preferred type of invoice finance sought. With invoice discounting the factoring company does not take over the administration of the trade receivables ledger. Instead, the administration charge covers the costs for: making updates to the sales ledger and periodic inspections of the accounts. These reduced duties are reflected in a smaller administration charge for invoice discounting. If, however, recourse or non-recourse factoring is sought then the administration charge will be more because the factoring facility will include the costs of administrating the trade receivables ledger and the costs for collecting from debtors.
In deciding the administration charge for factoring the factoring company will want further information about the following:
- The number of invoices and credit notes issued for a given volume of sales;
- The number of payments made by debtors for the same volume of sales described in point one;
- The number of active debtor accounts and the number of new debtor accounts (including old accounts that are re-opened);
- The number of times a debt has been discounted in order to facilitate a payment; and
- The extent of other charges incurred by the business such as returning pallets.
This information will help the factoring company determine how much work will be involved in administrating the sales ledger for a company under a factoring facility.
As alluded to, the administration charge will be higher if non-recourse factoring is preferred. The factoring company will accept a certain level of risk of non-payment of an invoice because of debtor insolvency and increase their fee accordingly. The level of risk is also reflected in the percentage of the unpaid invoice a factoring company is willing to make in prepayments.
The invoice financier assigned to a client will have industry specific knowledge to help determine acceptable risks when taking on the collection of unpaid invoices, and will decide which invoices are too risky to offer factoring for.
The invoice financier will also require records from the last three to five years detailing losses suffered by his or her client. This will allow him or her to review the quality of the debtors his client company has.
The Percentage of Prepayment
A factoring company will carefully consider what percentage of the value of unpaid invoices it will release in prepayment. The invoice financier assigned to the company will inspect the sales accounts for at least a year to determine the percentage of invoices that are not settled by debtors on time. This can be because of disputes about delivery, faulty invoicing and because of bad debts (the debtor is unable to pay). This will inform his or her decision about the maximum percentage the factoring company is willing to pay in advance on an unpaid invoice. Once this percentage figure is derived a further percentage will be deducted to provide for the set-off of recourse. This is to cover the costs for legal proceedings if a debtor defaults on payment. A further discount on the prepayment percentage will be made to allow for the possibility that the client will go insolvent and its debtors will query or stop payments because of post-invoice contractual obligations like rejection of delivered goods.
There are two main fees associated with factoring. They are the discount charge and the administration charge.
The discount charge is primarily concerned with the cost of borrowing and is normally calculated as a spread above the base rate that the central bank gives for borrowing. This charge is adjusted to reflect the attractiveness of a company in terms of product, management team and its track record for collecting on debt.
The administration fee is for the on-going costs of taking over a company’s sales ledger, inspecting accounting procedures, sending documents and costs for collecting debts. A factoring company will closely inspect the business records of its client over the last three to five years to get an accurate estimate for the costs of running a factoring facility for a company.
Finally, there is the prepayment percentage which determines what percentage of an unpaid invoice the factoring company is prepared to give in advance to its client. This is also informed by historical records of its client performance and takes into account the costs for recourse and the risk of the client going insolvent and its debtors withholding payment on the grounds of post-invoice contractual obligations.