Factoring And Invoice Discounting: Part 2 of 5 How Does Receivables Finance Work?

To see how factoring and invoice discounting works in principle, imagine for a moment that as soon as you have made a sale to a customer, you are then able to immediately 'sell' your unpaid invoice to a lender at its full face value.

The lender will then pay you for these in two instalments:

- an initial payment of the majority of the value (known as the 'advance', which is usually between 65% and 85% of the gross invoice value, ie including VAT if applicable); with

- the remaining balance being paid over, less the lender's charges, once your customer has paid the invoice.

The impact of this is to 'short circuit' most of your wait for payment by your customers after a sale as the lender is providing you with the bulk of payment immediately through the advance.

Of course in reality the lender does not actually purchase your debt but will instead take a first fixed charge over them as security for the advance. As a result, your debtors will not be available for your bank to use to secure an overdraft facility. Completion of a factoring or invoice discounting deal therefore usually involves paying off your overdraft out of an initial advance received from the lenders 'take on' of your existing debtor book.

Some invoice discounters may also take finished goods stock into account. As a result they can then offer higher levels of advance against your outstanding invoices (sometimes exceeding 100% of your debtor book).

As with most things in life the reality of this type of funding is in practice more complex as not all debt can be used to raise finance and as a result, the 'headline' levels of advance quoted by lenders can be misleading.

What Is Factorable Debt?

As with most commercial lending the key issue that determines how much you can borrow will be the value of the asset offered as security for the loan, in this case your debtors.

However not all debt can be factored or discounted (and avoid unnecessary duplication the generic terms factor and factoring will be used to cover both types of debtor based funding throughout the rest of this series of articles except where there is a specific difference in how they operate).

Some debts are in practice simply impossible to factor as lenders cannot rely on them as security. This includes:

Items sold on a sale or return basis, as the customer can always return the goods and cancel the debt on which the lender has already advanced. For a debt to be factorable there has to have been be a clean sale.

Even so, debts due on a 'pay when paid' basis will not be factorable as the lender cannot necessarily determine a specific point at which the invoice raised will become due and payable, if indeed it ever does.

The debt must normally be due from another business (a business to business or 'B2B' sale). Factors are not interested in or set up to collect debts due from consumers ('B2C' sales). Factors are also wary of sales to government bodies but some will fund against sales to local authorities or quasi governmental and public sector organisations.

The transaction must be with a genuine 'third-party' as factors will all disallow any intercompany trading within a group.

To the extent that a debt is due from a business which is also a supplier to the business, the lender faces the risk that the customer will set off ('contra') any sums that are due to them as suppliers against the debt due to the business. Any such debts will be excluded from the funding arrangement and a reserve will be placed on the account which restricts the drawdown available so as to cover this risk for the factor.

So if you are thinking about using debtor based finance it is important not to simply use the headline advance rate quoted when calculating the funding an arrangement will generate or preparing a cash flow forecast, but to discount this by a factor to allow for the above factors as well as any debt which is difficult to fund, which is discussed in the next article.