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Factoring explained

Last updated: 01 April 2022

Factoring explained

Factoring companies provide a flexible and cost effective way to free up capital and improve cash flow. Over 47,000 UK businesses use factoring and invoice discounting and it can be particularly useful for younger businesses or start-ups which experience cash flow difficulties. All factoring companies are not alike and choosing the wrong one could cost you dearly.

How does factoring work, how much will it cost and what are the advantages and disadvantages of factoring for your business? These are the crucial questions you must ask right at the beginning.

Factoring and invoice discounting are forms of invoice finance which allow business to raise funds or aid cash flow by providing funds against unpaid invoices. While business loans offer the advantage of a lump sum for immediate investment and business overdrafts can help fill certain financial gaps, factoring can provide a steady and reliable cash flow.

Basically you simply present your invoice value to the factoring company who will pay a percentage of the value of it into your bank – normally within 24 hours. It might be 80, or even 90% of the total value of the invoice. The bank then collects payment from the customer for you, saving you the time and hassle of chasing payments. Once payment is collected the bank pays the balance of the invoice value, minus agreed fees.


Factoring fees

Factoring is generally suitable for all business types, but it depends on sales. The more invoices you generate the more you can borrow. Charges vary – normally up to 3% over base rate for the money borrowed, together with a service charge linked to gross turnover (normally at least 0.5%).

Some factors offer bad debt protection as part of the package (known as “non recourse factoring”) so if a credit approved customer fails to pay an undisputed debt, the factor will credit you with the amount of the debt up to the agreed credit limit. This service normally increases the service charge by around 0.5%.

A cheaper solution is confidential invoice discounting which provides funding against UK and/or export invoices but is undisclosed to your customers and means you keep control of credit management. However it is generally useful for well-established businesses with strong balance sheets and track records and costs are less. Minimum charges apply. Money is not available for old or disputed invoices.


Advantages of factoring

  • the only assets required to borrow against are you invoices. So if you are asset poor it can be a good way of getting money
  • you will know that within an agreed amount of time from presenting the invoice to the bank or factoring company (often only 24 hours) 80% or more of the invoice value will be in your bank account
  • managing debt becomes easier and your cash flow can improve – you don’t have to rely on a customer’s whim to pay you in 30, 60 or 90 days
  • you can concentrate on running your business without having to chase up debt (which is often time consuming and stressful)
  • invoices presented from a bank or factoring company may get paid earlier than if you presented them to the customer yourself
  • most factoring companies will offer a certain amount of credit
  • factoring is flexible – as sales increase you can have the vast majority of money in your bank account incredibly quickly


Disadvantages of factoring

Factoring is not for everyone and you should carefully consider the small print before signing any agreement. Remember also that:

  • the factoring company will take a percentage of the value of each invoice it pays you for
  • there may be additional fees if you choose to outsource credit management
  • although the factor company will fund your invoices, you will still be liable for bad debts should the payees not settle their bills. Therefore you should still consider credit protection
  • you will need a certain amount in sales before factoring companies will consider you
  • there may be cheaper ways to raise money for your particular business
  • some customers may be put off
  • there may be a long tie-in with certain factoring agencies , so check carefully
  • factoring companies may impose conditions you do not like
  • you may lose a valued link with customers
  • if your factoring company is aggressive you may get your money but could sour relationship with potential long term customers
  • the quality of the factoring company’s service is absolutely crucial – choose a poor one and your business will suffer.


Questions to ask all factoring companies

  • What are the procedures?
  • What rates will you pay?
  • How much money can be leveraged against your debt book?
  • What is the invoice factoring company’s record on collecting money quickly and efficiently?
  • How will the invoice factoring company maintain good relations with your clients?
  • Does the factoring company experienced in your market sector?
  • What period of notice do you need to give the invoice factoring company? This is crucial.
  • Where is it based?

However, if you weigh up the advantages and disadvantages carefully and seek professional advice, factoring can be useful for a range of companies, especially those that wish to increase day to day working capital. Factoring is a useful bridge between raising and settling invoices and is useful for keeping a smooth cash flow. And cash flow will always be at the heart of your business.

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