Factoring And Invoice Discounting: Part 2 of 5 How Does Receivables Finance Work?

Asset - Factoring And Invoice Discounting: Part 2 of 5 How Does Receivables Finance Work?

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To see how factoring and invoice discounting works in principle, imagine for a moment that as soon as you have made a sale to a customer, you are then able to immediately 'sell' your unpaid invoice to a lender at its full face value.

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The lender will then pay you for these in two instalments:

- an introductory cost of the majority of the value (known as the 'advance', which is commonly in the middle of 65% and 85% of the gross invoice value, so together with any Vat element if applicable); with

- the remaining balance being paid over, less the lender's charges, once your buyer has paid the invoice.

The impact of this is to 'short circuit' your business's wait for the receipt of most of the cost from your customers after a sale as the lender is providing you with the bulk of cost immediately through the advance.

Of policy in reality the lender does not genuinely purchase your debt but will instead take a first fixed charge over them as safety for the advance. As a result, your debtors will not be ready for your bank to use to gather an overdraft facility. Completion of a factoring or invoice discounting deal therefore commonly involves paying off your overdraft out of an introductory progress received from the lenders 'take on' of your existing debtor book.

Some invoice discounters may also take fulfilled, goods stock into account. As a ensue they can then offer higher levels of progress against your outstanding invoices (sometimes exceeding 100% of your debtor book).

As with most things in life the reality of this type of funding is in convention more involved as not all debt can be used to raise finance and as a result, the 'headline' levels of progress quoted by lenders can be misleading.

What Is Factorable Debt?

As with most commercial lending the key issue that determines how much you can borrow will be the value of the asset offered as safety for the loan, in this case your debtors.

However not all debt can be factored or discounted (and avoid unnecessary duplication the generic terms factor and factoring will be used to cover both types of debtor based funding throughout the rest of this series of articles except where there is a specific distinction in how they operate).

Some debts are in convention simply impossible to factor as lenders cannot rely on them as security. This includes:

Items sold on a sale or return basis, as the buyer can always return the goods and cancel the debt on which the lender has already advanced. For a debt to be factorable there must be a clean sale.

Even so, any debt which exists on a 'pay when paid' basis as happens, for example, where a buyer may be keeping a consignment of stock, will not be factorable as the lender cannot necessarily conclude a specific point at which the invoice raised will come to be due and payable, if genuinely it ever does.

The debt must commonly be due from an additional one business (a business to business or 'B2B' sale) as factors are not curious in or set up to gather debts due from consumers ('B2C' sales). Factors are also wary of sales to government bodies but some will fund against sales to local authorities or quasi governmental and public sector organisations.

The other business must be a genuine 'third-party' as factors will all reduction any intercompany trading within a group.

To the extent that a debt is due from a business which is also a provider to the business, the lender faces the risk that the buyer will set off ('contra') any sums that are due to them as suppliers against the debt due to the business. Any such debts will be excluded from the funding arrangement or a retain placed on the inventory which restricts the drawdown ready so as to cover this risk for the factor.

So if you are reasoning about using debtor based finance it is leading not to simply use the headline progress rate quoted when calculating the funding an arrangement will create or making ready a cash flow forecast, but to reduction this by a factor to allow for the above factors as well as any debt which is difficult to fund, which is discussed in the next article.

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