What is factoring? (and how does it work)

Factoring is a term that in general business use describes a method by which companies can borrow money on a short-term basis. It is currently the fasting growing method employed by businesses to finance cash flow and is rapidly catching-up the traditional overdraft as the predominant form of short-term cashflow financing.

In fact, whilst the term “borrow” best describes the process to an outsider, it is technically incorrect to describe it as such, for the basis of the contract is that the factoring company purchases trade debts from the client at a discount. The nearest parallel is probably the overdraft secured by a debenture which includes a charge on book debts.

However, to compare factoring with borrowing on overdraft, either in terms of its cost or its application would be misleading, as factoring is a far more dynamic and a more flexible form of funding.

Put simply, factoring is an arrangement that allows a business to realise immediately the cash benefit of its sales. This is achieved by assigning sales invoices to a Factor who typically will pay up to 80-85% of their face value to the borrower with the balance (less costs) being paid once payment is received from the debtor.

Assignment – a transfer of ownership of a debt

It follows that factoring only works when sales are being generated but once this is being achieved the funding availability is directly proportional to the sales level. This means that the company should always have sufficient working capital to fund its growth.

The term “factoring” is used generically to describe the invoice discounting industry although use of the single word is something of a misnomer. More correct would be use of the American term “receivables discounting” whilst the more complete but somewhat cumbersome UK description is “factoring and invoice discounting”. A further term increasing in general use in the UK and used to describe the industry is “sales ledger finance”.

The three components that make up the service are:

• Finance an advance secured against outstanding eligible invoices
• Credit Management or, put another way – the outsourcing of the company’s sales ledger and credit control system to the factoring company.
• Credit Protection protection against bad debts.

Depending on the combination of these three, the service can be known as factoring (recourse or non-recourse) or invoice discounting (recourse or non-recourse).

With invoice discounting the borrowing company retains control of its sales ledger and the funding against the invoices may be confidential between the Factor and the Borrower or disclosed, in which case disclosure is made by printing a notification of the assignment on each invoice.

In between full service factoring and invoice discounting there are several hybrid services such as Client Handles Own Collections (CHOCS) also known as bulk factoring or agency factoring which offer a discounting service but with a little more security for the factoring company.