Factoring receivables describes a form of invoice finance that allows businesses to sell their outstanding invoices (accounts receivables) to factoring companies. Whilst outstanding invoices are sold at a discount, the business then benefits from money upfront rather than having to wait for their clients to pay. This can increase cash flow and leave the business with more capital on hand to continue everyday operations and to grow.
Below we look at how factoring receivables works, what options companies have, and how it could help to improve the cash flow outlook of your business.
Factoring receivables, also known as invoice factoring, is a form of invoice finance that allows a company to sell its outstanding receivables to a factoring company. This company then collects payment of the outstanding invoices from the business’s customers.
Businesses tend to consider how to factor receivables when they want to receive money quickly rather than waiting for their payment term to elapse. Getting the money upfront allows businesses to improve their cash flow and pay their own outstanding obligations – freeing up working capital in the process.
In many cases a company will turn to factoring its receivables to cover gaps in its working capital or cash flow. These generally occur where there is a delay between invoicing a client and getting paid, which can make it difficult to cover operational costs in the interim.
Businesses of all sizes grapple with gaps in their cash flow because their payment terms allow their clients to pay within a specified, and often quite lengthy, period. What this can mean is that businesses might go for as long as a few months before they see any money for the work they’ve completed or products they’ve sold.
Invoice factoring can help a business to overcome cash flow issues by providing a percentage of the value owed in receivables upfront even before they’re paid. In most cases, the finance company will then take on responsibility for collecting the invoice, leaving the business and its management team to get on with what they do best while collecting a small fee for the service.
Your business may need to explore how its finance team can follow UK GAAP accounting for factoring. How you choose to record accounts receivable factoring will depend on your business’s accounting procedures, but the good news is that it doesn’t have to be hard!
Taking the example of a business with £100,000 of outstanding invoices that needs working capital to start a new project and make payroll. The business owner might decide to sell the receivables to a finance company in a process known as factoring. The factoring company might then agree to terms which look something like this:
The factoring company will purchase the accounts receivable;
They will impose a finance charge of 3%;
In ongoing factoring relationships, the factoring company may retain 20% of the gross accounts receivable purchased as a reserve. This might be recorded by your accounting team as ‘Due from factor’.
The factoring company acknowledges sales discounts, but will charges these costs from the ‘Due from Factor’ facility.
This leaves us with a factored accounts receivable example where £100,000 worth of receivables are sold, with a 3% financing fee, a 20% reserve requirement, estimated sales discounts of £5,000, and fees of £100. To record this information, the business will follow three steps:
Step 1: After selling your accounts receivable, the business will receive £77,000 from the factoring company, recording a ‘loss on the sale’ of the receivables of £3,000. This represents the 3% financing fee charged by the factoring company. The receivables will also be taken off of the business’s books as they will now be owned by the factoring company. A ‘due from factor’ figure of £20,000 will also be recorded, as this sum will be held in reserve by the factor until after they have collected invoiced funds from the business’s customers.
Step 2: As the factoring company sets out to collect money from your customers, it might be that only £90,000 of the total £100,000 is received. With pre-agreed sales discounts of £5,000 and factoring fees of £1,000, your business will need to reduce its ‘due from factor’ figure by £6,000.
Step 3: Once the factoring company has collected all final payments from your customers (assuming that they all pay the full amount owed), they will remit the remainder of the reserve account to your business. This ties off the factoring arrangement, although it may of course turn into an ongoing arrangement.
There are two main varieties of invoice factoring – with recourse and without recourse.
When factoring receivables with recourse, a business will have to repay the value of an invoice if their customers do not settle what they owe with the factoring company.
Contrastingly, factoring without recourse (or non-recourse factoring) sees the factoring company assume most of the risk for receivables that cannot be collected. In most cases this protects the business against liability for unpaid funds in the event that their customer becomes insolvent during the factoring period.
Reverse factoring, known also as supply chain financing, is a financing method that is initiated by the customer rather than the supplier. Whereas invoice factoring entails a business selling its accounts receivable, reverse factoring involves the factoring company paying a supplier’s invoice quickly and at a slightly reduced rate. This gives the supplier the working capital they need to maintain their business whilst allowing more breathing room for the buyer on account of having an extended payment period.
Factoring receivables can help businesses to cope with their ongoing operational expenses even despite having long payment terms. This form of invoice finance is perhaps most suitable for businesses that struggle with cash flow shortages, are growing quickly and need working capital, or for those who do not want to pursue more traditional forms of financing such as bank loans. Whilst it does mean giving up a portion of your business’s profits, there are many upsides to factoring receivables, including:
Fast access to working capital, whether you need to fund a new business project or cover operational costs. Traditional financing can take a long time to come through, whereas factoring receivables could see money hitting your business account within just days of raising an invoice.
An easy way to build your company’s credit profile, as some factoring companies report to credit bureaus. This means that a good working relationship with a factoring company could enhance your business’s ability to access credit in the future.
Better customer relationships, as the financing company deals with the collection of invoices. This means that the relationship between you and your customers can be refocussed on your work and products.
Your business could benefit from better cash flow and high levels of working capital, all by factoring receivables. Various financing companies use a different factoring receivables formula, and so it can be difficult to know whether you’re getting the best deal.
Fortunately, there’s no need to take a shot in the dark as you can compare some of the UK’s very best factoring companies by using our quick and simple comparison tool. Try it today to find out how your business can improve its cash flow cheaply and easily. No fuss, just the invoice finance that you need.