Debt Factoring

Introduction

Factoring is not new, it originated in England in the 1300s. Today it is a common method of financing business transactions.

The factoring company purchases a business’ debtors’ invoices for a fee. The benefit to the business is that it receives cash for a high percentage of its debtors’ invoices, virtually simultaneously with the sale.

 

How does it work?

There are a number of well-established companies which offer factoring. The business operator negotiates with the factorer, who agrees to make factoring facilities available for a set fee, and to make a set percentage cash advance to the business operator.

The deal normally involves the factoring company agreeing to pay for a high percentage of a small business’ approved invoices within 48 hours of the invoices being presented to the factoring company.

The following example will highlight how factoring works:

  • ABC Company agrees to sell to XYZ and the sale price is $10,000
  • ABC Company forwards the original copy of the invoice to XYZ (the customer) and presents a copy of the invoice to the factoring company. (So long as the purchaser (XYZ) has been approved by the factorer). The factoring company will deduct the value of its factoring fee, say around 2% or 3% above the bank bill rate from the invoices presented to it (say $200)
  • The factoring company calculates the advance percentage that has been agreed upon for that particular customer, say 80%. ABC would receive $7,840 as an advance against the invoices made out to XYZ. ($10,000 – $200 = $9,800 × 80% = $7,840)
  • When XYZ subsequently pays in 70 days’ time, $10,000 would be received. Of this, the factoring company would retain its original fee of $200 and the advance of $7,840, a total of $8,040, and would remit the balance still owing to ABC of $1,960
  • The business ultimately has received $9,800 — and had the use of $7,840 for the 70 days that it took XYZ to pay

You would undertake this procedure with the statements having been forwarded in the name of the factoring company.

 

Undisclosed factoring

There is an alternative method of factoring, which is ‘undisclosed’ factoring, in that the business’ customers are not aware that the debtors have been factored.

This means that invoices, statements etc. do not mention in any way the name of the factoring company.

This can mean that a higher fee is paid, but it is perceived that the client benefits in that it is not known that debtors are being factored.

 

Benefits

Factoring can have tremendous cash flow benefits for small business operators.

In the example given, the customer XYZ would normally have taken until 70 days after the invoice is raised, to pay for the goods.

If ABC was factoring its debts then the company would receive the use of $7,840 within about 48 hours of the invoice being written.

This means that the bulk of the amounts owing would be in the possession of the small business for approximately 68 days prior to the normal payment date.

 

What do you do with the money?

If you are using factoring you will be able to use the cash generated to reduce other borrowings or buy product at favourable purchase prices.

 

Acceptance of factoring

Factoring has become more popular in New Zealand business and it is one financing opportunity that small business operators should be considering if they have to trade with customers on a credit basis.

 

Implementation

Debt factoring should be carefully implemented. It is a good idea to tell your customers you plan to use the services of a factoring company, and why. Unless you explain otherwise, they might see the move as an indication that your business is in trouble and start to source alternative suppliers.

 

Factorer requirements

Many factoring companies have restrictions on the size of the business that they are prepared to deal with and most demand annual credit sales of at least $300,000 before they will consider making factoring available. However check the marketplace as to the type of deals that can be negotiated.

The factoring company will also require to sight annual financial statements together with periodic financial statements, your business plan, and possibly a cash flow forecast for the coming year. They will require permission to conduct an audit on your debtors’ affairs.

Many small businesses have found that the inconvenience of the factoring company controls, and the fees, are acceptable by allowing them the benefits of substantially improved cash flow from their credit sales.