A factoring firm has to decide on the suitability of a prospective client. There are the needs of the company to consider – is invoice financing too expensive? Is it the best way to improve the company’s cash flow? And from the factoring firm’s point of view the main point of consideration might be whether the company’s customers are likely to pay their invoices.
There are no hard and fast rules for deciding the suitability of a company for invoice finance services. Rather there are a set of guidelines to consider. The only precondition for factoring is that the invoice must be for a B2B transaction. Retail invoices are not suitable for invoice finance.
Certain business sectors are considered more suitable than others.
Some businesses set up payment conditions that make factoring and invoice discounting unsuitable. These include a return policy – allowing a customer to return a product if they are not happy with it. Stage payments such as in construction, where payments are staggered and dependent on passing set criteria. Pay when paid which allows the customer to delay payment until the goods or services purchased have generated enough money to pay. And self billing where the customer only pays for what they calculate they have used.
What Does the Factoring Firm Look At?
If a company is keen to release cash tied up in unpaid invoices and it passes the suitable sector test then a factoring firm will take a deeper look into the prospective client. They look at the financial position of the company, its track record, its credit rating, its previous disputes and the composition of its ledger of unpaid invoices. All these aspects indicate whether there is likely to be problems with the payment of invoices.
What Happens Next?
If an invoice financier is satisfied that a company is operating in a sector that is suitable for factoring or invoice discounting; and if the invoice financier is satisfied that the company is in good financial health with regular paying customers then a business report is written that makes an offer. It is approved by the underwriters.
Crucially the business report contains a list of charges so that the company will know how much it has to pay for invoice finance services. It also contains the type of invoice finance that is being offered – recourse or non-recourse factoring; disclosed or confidential invoice discounting. If the company’s clients are based abroad export factoring might be offered.
The report will also state what percentage of an unpaid invoice will be released before the customer pays the debt. The more certain the factoring firm is that an invoice will be paid on time, the higher the percentage they will offer.
Terms are also stated. These cover the maximum amount the factoring firm will cover for any particular debtor, the contract length and the notice period. A company needs to study these so that they are fully aware of its options if it chooses to cease using invoice finance services.
Lastly, if the company is happy with the business report and the offer contained therein then they indicate to the factoring firm that they are ready to enter into a legally binding agreement. The invoice financier will then produce documents to be completed and signed so that factoring or invoice discounting can begin.
And the Factoring Begins
A company will send over its ledger (list of unpaid invoices) to the factoring firm. The factoring firm will then decide which invoices it will provide prepayments for and which they will not.
To see the full list of actions involved in both factoring and invoice financing see our post Factoring and Invoice Financing.
There are certain sectors of the economy that factoring companies have traditionally been wary to enter. This is because of the way payments are made or because of the risk of a debtor not paying. Moreover, there are some payment arrangements in business that deter factoring companies, such as offering sale or return. This makes an invoice amount uncertain. It is certainty that a factoring firm requires – certainty of payment of an invoice.
Once a company has cleared these entry requirements a factoring firm will make a written offer that has been approved by the underwriters.
And, finally, once a factoring agreement has been entered into then the factoring company will constantly monitor performance and make adjustments accordingly. The primary concern is risk, and the best way to calculate and manage risk.