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Factoring: Receivables finance, or how to turn the problem of unpaid invoices into immediate cash
Receivables finance is a concept, called by many other names, which basically means that a company’s invoices will be paid by a financier before the end-customer who was delivered the goods or services.
I) What is receivables finance ?
Known by many other names, this type of financial tool encompasses many products.
Receivables finance, or accounts receivables financing, or debtor finance, or invoice financing, is a type of financing solution in which a company uses its receivables - the money owed by its customers - as collateral in a financing contract. The company - called the “client” - receives, generally in two instalments, an amount corresponding to a diminished value of the receivables claimed. This works as an alternate growth-funding solution to traditional bank loans.
Although receivables finance encompasses both invoice discounting and factoring, the term is sometimes used to refer to both types of plans collectively.
- Strictly speaking, factoring or debt factoring means that the factors will claim and collect the money owed by end-customers themselves, as the invoice is sold to the factor.
- Invoice discounting means that the invoice financier will not manage the client’s sales ledger and collect debts on behalf of his client, but lend money against the invoices, with a fee. The client keeps control of the administration of his debtors.
2) Examples of receivables finance
If a company has a balance sheet of £200,000, and needs to borrow £100,000, then their balance sheet increases to £300,000.
If they choose to sell off the £100,000 in outstanding invoices, rather than borrow these £100,000, their balance sheet will remain at £200,000.
In a factoring agreement, the £80,000 will be paid to the client as soon as the £100,000 invoice is issued, and the remainder, £20,000, minus fees of £5,000, as soon as the end-customer pays the invoice.
In an invoice discounting scheme, the service is undisclosed to the customer and the money will be paid by the end-customer to a bank account administered by the account discounter.
II) Risks and costs
Risks involved in receivables finance means the financier will usually run a credit history check comparable to what could be asked for a loan. Costs will vary depending on this credit history.
1) Risks need to be weighed by the company - and by the financier...
The company interested in invoice financing will need to provide detailed bookkeeping records to the financier in order to have an optimal rate. The more information the financier gets, the more accurately he can calculate the risk, and therefore, lower the fees.
That means the client should check his accounts before deciding to choose a receivables finance option: if many of his end-customers have a history of bad payment performance, the advance rate agreed by the factor will be reduced.
2) ... so that rates can be competitive
Since many factoring providers are now offering debtor finance plans, competition puts a pressure on fees. However, advance rate, discount charge and service charge will still depend on the client’s customers payment performance history:
- Advance rate, or the proportion of invoiced amounts that will be advanced, may be as high as 100% and as low as 50%;
- The discount charge is calculated on the basis of day-to-day usage of funds. It is usually comparable to secured bank overdraft rates.
- In the case of factoring, the service charge can be in the range of 0.75% to 2.5% of managed turnover, depending on the workload
- In the case of invoice discounting, service charges will be lower or even waived.
Another element that needs to be considered and will vary depending on the credit history of the client is the minimum amount of invoices or turnover needed to enter an agreement. When invoice discounting is considered, a turnover in excess of £150,000 will usually be required.
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