Invoice factoring is a powerful tool that allows a business in need of cash to secure those finances quickly. A business essentially trades invoices due in the future for two payments that equal the value of those invoices, minus fees.
Invoice factoring can seem intimidating at first, but one of the best ways to start wrapping your head around certain concepts is through examples. These can help us understand the kinds of decisions within invoice factoring that can be useful for your business.
Let’s start with this example: Your business is facing a shortfall and needs ££8,000, but finds itself having to decide whether to factor an invoice for a reliable customer or an invoice for an unreliable one. We’ll stick with round figures as much as we can so it remains easy to keep track of the numbers.
Breaking Down the Payments
As mentioned above, you can’t just factor £8,000 worth of invoices and expect that amount right away. Invoice factoring involves two payments. The first payment is the advance. This is the bulk of what your invoices are worth, and might range between 70- to 90-percent of the total. The second payment is the reserve amount. This is made when the factoring company receives payment on the invoices from your customers, and pays the remainder of what they owe you for those invoices.
Let’s say you’re in a fairly safe industry, your business has a good credit rating, and the risk factors involved for loaning you money are low – but this is the first time you’ve worked with a particular factoring company and they don’t have history with you. They may agree to pay you 80-percent of your invoices’ value up front, with the remainder paid once the factored invoices are paid to them.
Since your business needs cash now, you don’t just need the total they pay you to equal £8,000. You need that first payment they pay you to equal £8,000. That means you need to factor £10,000 worth of invoices, so that the 80-percent advance the factoring company gives you equals £8,000.
A Bump in the Road – Which Invoices to Choose?
Let’s give ourselves a bump in the road. Imagine your invoices are fairly large and you’ve already assembled £9,500 worth of invoices to factor. That leaves you only £500 worth of invoices left to factor, but you only have invoices that are larger than that left.
Every invoice you factor loses a little bit of value in the long-term because the factoring company takes a fee out of the total. Obviously, you’ll aim for the additional invoice that puts you the least over – but there’s a problem.
Let’s say there’s a £700 invoice from an unreliable customer. This customer pays late fairly often. You let him because you know he’ll pay eventually, and you choose not to punish him because he’s a repeat customer – but the factoring company won’t know any of this and can’t necessarily make those kinds of exceptions.
That would put you at £10,200.
The next closest invoice is for £1,000. This customer is very reliable and pays on time every time. But her invoice would put you at £10,500.
Where the Fees Come In
The factoring company’s fees may amount to 3-per cent of the total value of the invoices per month. In other words, if you had been able to get to £10,000 even, the breakdown would look like this:
Advance payment made right away: £8,000
Reserve amount paid when invoices are paid in 30 days: £1,700
Factoring fee: £300
This means that the £300 difference between that £700 invoice that might be paid on time and the £1,000 invoice that almost certainly will is a fee of £9. If the amounts are generally the same, and even if it puts you at a higher amount than you intended to factor, always factor your more reliable invoices first.
If the Customer Fails to Pay
If you had gone with the £700 invoice, and it wasn’t paid, you might be on the hook for another £300 if the entire factoring amount rolls over into a new month. If the factoring company understands your predicament and only charges the fee for the outstanding amount, that’s still another £21 instead of £9 that you would’ve paid.
If the factoring company is sensitive enough to offer that, a difference of £12 doesn’t sound so bad, but it also means you won’t see that reserve amount paid back to you until the customer finishes paying the invoice. If that customer is an extra month late, you just tied up more than £1,600 of the reserve amount for an additional month. For a company that needed an infusion of £8,000 right away, you probably can’t afford to tie up an extra £1,600.
And since the rates scale up similarly, if your company needs an extra £80,000, you probably can’t afford to tie up an extra £16,000 simply because you factored an unreliable invoice instead of a reliable one.
Now, a recourse factoring agreement means the factoring company can come after your business if an invoice isn’t paid by the customer. That means you’ll be on the hook for that £700 your customer never paid.
A non-recourse factoring agreement means the factoring company can’t come after your business in the event of an unpaid invoice. However, this may mean that regular customer you always let get away with late payments is suddenly on the hook for a late payment. As a result, you may lose them as a customer.
There are just too many reasons to factor reliable invoices before unreliable ones:
- The amount you might save in initial fees usually won’t match the amount you owe if a customer misses an invoice payment.
- Don’t get that second payment, the reserve amount, tied up an extra month or two. That can be 10- to 30-percent of the total value of those invoices.
- You don’t want to be on the hook with a recourse company for an invoice that was once owed to you.
- You don’t want a customer to be penalised by a factoring company in a way you wouldn’t penalise them.
- You may want to do business with this factoring company again. If you’re reliable, they may give you more favourable terms next time.