How Invoice Factoring Works

Why Factor Your Invoices?

If you give credit to your customers or clients and your business is struggling due to cash flow (not having enough cash to pay suppliers because you are waiting for your customers to pay you), factoring your sales invoices – so that you receive some of your sales income quicker – is one way that could help your cashflow.

What is Invoice Factoring?

Factoring or Debt Factoring is typically used by business to help cash flow

Factoring involves you selling your business’s sales invoices to a Factoring company, at a discount.  The business is then able to “draw down” cash against the sales invoices and the Factor (as Factoring companies are known) collects the money from your customers, acting as your sales ledger and credit control team.

The Factoring Process

Every time a sales invoice is raised, a copy must be sent to the Factor as well as to the customer.  (Some Factors will also raise the sales invoices, which eliminates this step).

The sales invoice is marked as being factored, and the customer is required to pay the Factor direct.

You can withdraw or “draw down” up to 85% of the sales invoice.  (Some Factors will withhold the VAT element until the end of the VAT quarter, eliminating the problem of not having enough funds to pay the VAT to HMRC)

The Factor will maintain the sales ledger (posting sales invoices and payments to each customer account) and also carry out credit control (chasing customers for payment)

When the customer pays, the balance of that sales invoice may be also be withdrawn (less a discount fee withheld by the Factor)

At the end of each month, the Factor sends out statements for the sales ledger, the overall account position/availability of funds – including Factoring charges and discount fees.

The availability of funds or “Client Availability” (or sometimes confusingly called the “Client Balance” – this is because you are the client of the Factoring company) is  the amount of money that can be withdrawn or “drawn down” from the Factor)

If a sales invoice is not paid within a certain timeframe (typically within 3 months), in the case of a recourse agreement, that sales invoice becomes “disapproved” and the Factor will take the money back, normally by reducing the availability of funds.

Bookkeeping for Factoring

It’s advisable to treat the Factoring Account as a bank account in your bookkeeping.  Treat all withdrawals of funds from the Factor to the business’s own bank account as a bank transfer.

The sales ledger in the bookkeeping should mirror that of the Factor’s Sales ledger.  This means entering all sales invoices and customer payments to the relevent customer accounts.  The aged debt in the bookkeeping should therefore be the same as the aged debt report that the Factor produces.

Treat the factoring fees and discount charges in a similar way to bank charges.

Overall, the balance on the Factoring account in the bookkeeping should be the same as the liability to the Factor.  (It should be possible to check and reconcile this on at least a monthly basis)

Unfortunately, Factors produce statements that are primarily helpful to themselves.  Typically, the Factor will send at least two reports at the end of each month – the Sales Ledger (which should be mirrored in the bookkeeping) and the “Client Funds” statement (or “Funds in Use” or generally similar terminology – unfortunately, there is no standardisation, so each Factor uses its own variant terminolgy).

Some Factors’ statements make it very confusing to see what’s going on.  Care needs be taken that the overall “client liability” to the Factor is the figure that is being reconciled to.  With some factoring statements it is easy to confuse the “Client Availability” with the “Client Liability” figure.

There are special rules for showing “recourse” factoring in the final accounts.

Advantages of Factoring

• It is a quick boost to cash flow (assuming that the Factor’s conditions can be met)
• Some customers take Factors more seriously and pay quicker (also, the reverse is true)
• Non-recourse Factoring can protect against bad debts.
• Factors will credit check your customers which will help reduce bad-debts.
• Some Factors will withhold the VAT amount and transfer to you at the end of the VAT quarter, which saves you having to worry about putting it aside.

Disadvantages of Factoring

• Queries with sales invoices can be slower / more bureaucratic to deal with.
• It may reduce the scope for other borrowing, since you would already have effectively borrowed against the financial asset of your sales ledger debt.
• There will usually be a charge registered against your company that will be on the public record at Companies House – this will remain on the public record even if you end the factoring agreement.
• Factors will not fund or may restrict funding against poor quality customers.
• Leaving a Factoring arrangement means that you will have to repay off any money that you have withdrawn against your sales invoices (even if your customer has not paid)
• You have no direct control over your credit control and some customers will prefer to deal with you directly.
• Factoring is not cheap.  The usual financial costs  are the Factoring Fees and the Discount Fees.