Primary navigation:

QFINANCE Quick Links
QFINANCE Topics
QFINANCE Reference

Home > Cash Flow Management Best Practice > Factoring and Invoice Discounting: Working Capital Management Options

Cash Flow Management Best Practice

Factoring and Invoice Discounting: Working Capital Management Options

by Irena Jindrichovska

Factoring Example and the Cost of Factoring

Factoring represents a sale of accounts receivable to a financial institution, which acts as a factor. This may be a bank, or an independent factoring broker. There are three parties to this transaction: a client company (a producer that has provided services or produced goods, and issued invoices to its debtors, who need to pay invoices to the company under certain conditions); a debtor (the company that ought to pay the invoice to the producer in due time); and a factor that facilitates the transaction through buying the invoice from the client, and finances the amount over an agreed period.

Simple Illustration

The factor purchases £100 from its client under a factoring contract. The client company (borrower) receives, from the factor, 70% of the value of the invoice minus interest and service fees, and minus a factoring commission of, say, 2%. The client receives the remaining 30% upon receiving the payment from its customer. The amount of £30 serves as a reserve amount, and is kept by the factor until the invoice is paid.

At the beginning of the transaction, the factor advances £68 and acquires ownership of the whole receivable. When the invoice is paid in 31 days, the factor sends £30 to the client on day 31. The size of the reserve depends on the perceived risk of the client. There will be an additional cost, which will be the interest on the outstanding balance of receivables. The interest can be deducted at the beginning, at the same time as factoring the commission.

The client company pays a commission fee for the factoring service to the factor, as well as interest for the period of financing. The factor bears the risk of non-paying customers. The factor buys the receivable at a discount, which ranges from 0.35% to 4%. The interest for factoring is usually 1.5 to 3 percentage points above the base rate, reflecting the overall risk of the transaction, as well as current market conditions. The rates are roughly equivalent to bank overdraft rates, and can occasionally be better.

Case Study

The Cost of Factoring: A Short Summary

Background: The turnover of a client company is £750,000 per year, and debtors are taking an average of 50 days to pay on commencement of the factoring agreement.

The factoring company provides the following conditions:

Factoring commission: 1.25%

Factoring interest: 7.0% pa

Average credit period: 50 days

Convention 360 days in a year

Factoring commission cost:

1.25% x £750,000 £9,375

Factoring interest cost:

(£750,000 − £9,375) × 7% × 50 ÷ 360 £7,200

Total factoring costs: £16,575

The total cost of funding over the period of 50 days is £16,575. This needs to be compared with other funding options (e.g. bank loan) for optimization. (Adapted from Factoring solutions: www.factoringsolutions.co.uk, accessed December 10, 2008.)

Regulation of the Industry

Company cash flow, and its financial health, are very much affected by performance of its short-term assets. In this regard, the way factoring is arranged and managed is extremely important, as it directly affects the cash flow and financial health of a client company. Companies, therefore, need to pay close attention to choosing a good quality factor, because selecting the wrong factor can have a damaging effect on the company.

“Unfortunately, there isn’t any regulation of factoring companies, and equally unfortunately, as any knowledgeable factoring insider will tell you, the industry is badly in need of regulation, as currently the factoring companies exercise far too much power, and on the occasions when they abuse that power, the poor client has no one to complain to.” (Source: www.factoring-broker.org.uk, accessed December 10, 2008.)

Factoring is a complex, long-term agreement that could have major effects on the management and development of the client company. It is, therefore, advisable to take legal advice on the legal and financial implications of factoring.

Invoice Discounting

Invoice discounting is another policy used by firms to speed up collection of receivables. Invoice discounting is an alternative way of drawing money against a company’s receivables, i.e., issued invoices. In this case, the business retains control over the administration of receivables. It provides a cost-effective way for profitable businesses to improve their cash flow.

There are two parties to this transaction: the client company and the invoice discounter.

This service is provided by banks and financial institutions to businesses that sell products or services on credit to other businesses. It is normally available to businesses with a proven track record, and annual turnover of at least £500,000, and is usually a long-term relationship between the business and the invoice discounter.

The Mechanics of Invoice Discounting

The invoice discounter first checks the client company, its accounting, and production systems. It reviews the client’s accounting system, its customers, and its overall creditworthiness, and will then agree to pay a certain percentage of its total outstanding receivables.

The client company pays a monthly fee and interest on the net amount advanced. Typical fees range from 0.2% to 0.5% of discounted receivables. These fees are less than factoring fees, because only the financing service is provided.

“For example, if the invoice discounter agrees to advance 80% of the total owing, and the total of outstanding invoices is steadily changing, then so will the amount you receive. If the outstanding debt drops month on month, you must repay 80% of the fall in debt. If the debt rises month on month, you will receive 80% of the increase.” (Source: Adapted from Business Link, www.businesslink.gov.uk, accessed December 10, 2008.)

Back to Table of contents

Further reading

Books:

  • Bakker, M., L. Klapper, and G. Udell. Financing Small and Medium-size Enterprises with Factoring: Global Growth and Its Potential in Eastern Europe. Washington, DC: World Bank, 2004.
  • Booth, L., and W. S. Cleary. Introduction to Corporate Finance. Toronto, ON: Wiley, 2007.
  • Klapper, L. The Role of Factoring for Financing Small and Medium Enterprises. Washington, DC: World Bank, 2005.
  • Meckin, D. Naked Finance: Business and Finance Pure and Simple. London: Nicolas Brealey Publishing, 2007.

Article:

  • Soufani, K. “Factoring as a financing option: Evidence from the UK.” Working paper, Concordia University, 2003.

Websites:

Back to top

Share this page

  • Facebook
  • Twitter
  • LinkedIn
  • Bookmark and Share