Cash flow is substantial in any business – whether it is a small independent company or a global enterprise. Ready capital ensures growth and development of every corporation. However, even the most successful business can find itself restricted at times by late customer payments or the natural ebb and flow of income. Factoring is the answer when you need to gain immediate access to your working capital, streamlining your processes and giving you the ability to respond quickly to capitalise on investment opportunities.
History of factoring
Factoring is not a new idea. It originates as trade financing in the ancient Mesopotamian culture and its rules are preserved in the Code of Hammurabi.
Factoring in England as a fact of business life was underway prior to 1400, and accompanied the Pilgrims to America around 1620. It seems to be closely related to early merchant banking activities. Like all financial instruments, factoring has been evolving centuries, due to changes in the organization of companies, technology, particularly air travel and non-face to face communications technologies starting with the telegraph, followed by the telephone and then computers. Modifications of the common law framework in England and the United States also had its say.
Governments were latecomers to the facilitation of trade financed by factors. English common law originally held that unless the debtor was notified, the assignment between the seller of invoices and the factor was not valid. As late as the current century the courts have heard arguments that without notification of the debtor the assignment was not valid. In the United States, by 1949 the majority of state governments had adopted a rule that the debtor did not have to be notified thus opening up the possibility of non-notification factoring arrangements.
Originally the industry took physical possession of the goods, provided cash advances to the producer, financed the credit extended to the buyer and insured the credit strength of the buyer. In England the control over the trade thus obtained resulted in an Act of Parliament in 1696 to mitigate the monopoly power of the factors. With the development of larger firms who built their own sales forces, distribution channels, and knowledge of the financial strength of their customers, the needs for factoring services were reshaped and the industry became more specialized.
Today the most frequent factoring practices involve so-called ‘debt factoring’ and ‘invoice discounting’. How does it work?
Debt factoring usually involves an invoice financier managing your sales ledger and collecting money owed by your customers themselves. This means your customers will know you’re using invoice finance. It looks like this:
- You raise an invoice.
- Your Factor buys the debt owed to you by your customer and gives you usually around 85% of its value upfront.
- Then they collect the full amount directly from your customer.
- They pay you the remaining balance minus the discount charge and fees.
- With invoice discounting, the procedures are as follows:
- You have an invoice you have to pay.
- The Factor lends money against your unpaid invoice.
- Your customers pay their invoices.
- The money paid by your customers is directed to the Factor and reduce the amount you owe them, which allows you to borrow more money for the next invoices, up to the percentage settled at the agreement. Of course, you also have to pay the Factor interest and/or the fee you have agreed upon.
Advantages and disadvantages
Unlike short-term solutions such as a bank loan, factoring offers you the opportunity to make positive long term improvements to the way you run your company. The Factor will look after your sales ledger, which will give you more time to manage your business; They can credit check potential customers and help you to negotiate better terms with your suppliers. In case of invoice discounting, it can be arranged confidentially, so your customers won’t know that you’re borrowing against their invoices and it lets you maintain closer relationships with your customers, because you’re still managing their accounts.
On the other hand you’ll lose some profit from orders or services that you provide and it may affect your ability to get other funding, as you won’t have ‘book debts’ available as security. Your customers may prefer to deal with you directly and it may affect what they think of you if the Factor deals with them badly.