Factoring And Invoice Discounting: Part 4 Of 5 - How Do They Charge?

Factoring and invoice discounting are both forms of debtor based funding and their costs each include two main ongoing elements, a service charge to cover the facilities provided, and an interest charge based on the levels of funding borrowed.

Service Charges

These are usually calculated as a percentage of turnover and factoring tends to be more expensive than invoice discounting as the charges include the cost of providing the credit control service (and where applicable bad debt protection) where both the number of customers and the number of invoices being issued come into the equation for determining the costs. These charges are extreemely obvious and are one of the reasons why factoring has had a reputation as being expensive. However if you are comparing the cost of factoring to other sources of finance you will need to take into account any savings you may be making by outsourcing your credit control function.

If you are comparing the cost of debtor based finance to the cost of bank overdraft facilities, be sure to take into account any 'management' and 'arrangement' charges that your bank imposes, together with the cost of credit control and insurance.

Interest Costs

These will be quoted at a rate over base (or something similar such as LIBOR, the interbank borrowing rate) and which should therefore be directly comparable with interest rates on other types of lending.

Other Costs

There are however some other costs to take into account which include:

- any initial audit cost, to cover the cost of checking the asset to be lent against;

- a take on fee to cover the administrative costs of setting up the arrangement;

- separate credit insurance costs as the lender may require that you take out credit insurance cover on some or all of your debtors to ensure that if the customer fails, the cash can still be recovered;

- transaction costs which can include fees for telegraphic transfers (TTs); and if it ever comes to it,

- collect out costs, which is the charge a funder will impose to cover collecting in the debts if your business fails, so they are repaid.

What Happens If A Debt Goes Bad?

Most businesses suffer bad debts from time to time but this raises an obvious problem if you are using debtor based finance as you will already have received an advance in respect of the invoice when it was raised, so how do lenders deal with this situation?

Factoring can be on either: - a 'recourse' basis, where in the event a customer does not pay the lender, can recover the funds they have advanced to you from your current availability, leaving you exposed to the impact of the bad debt; or - a 'non-recourse' basis where if a customer fails to pay a debt where there are no grounds for dispute, this is the factor's problem not yours.

Obviously in non-recourse factoring the lender is taking a much greater risk, or will be bearing an expense in insuring the debt which will be reflected in the price of the service.

The factor will usually give you of a credit insured limit for each customer and this will be the figure up to which 'non-recourse' applies. So your exposure to a bad debt will be limited to any amount of credit you may have allowed over this limit.

What Happens If Your Business Gets Into Difficulty?

As with any lender, factors and invoice discounters will look to manage their risks if they think your company is getting into difficulty.

A factor has an immediate direct and disclosed relationship and contact with your debtors. This makes it easy for the lender to verify the debtor balances that are being held as security as well as putting them in a good position to collect in the debt if required. Factoring is therefore seen by lenders as a safer service to offer than invoice discounting. So, if an invoice discounter becomes concerned they will often move your account onto a factoring arrangement as a way of giving them a much closer grip on your debtors and their exposure.

Of course, as your facility under debtor based finance is broadly tied to sales volume, if sales fall it follows that the funding available will also fall (which may be just the moment that you need finance the most).

In addition to this 'natural' reduction, both forms of lender will ensure taht they actively manage down their exposure if they become concerned. They can do so by taking a more aggressive stance in disallowing debt and by placing either specific or general reserves on your account so that the percentage they have actually advanced against your total book reduces. In some cases the effective advance to a company in difficulty can drop as low as 20% of the total debtor book as a result of this sort of approach by a factor's operations department.

The impact of this approach can be to starve the client business of funds, sometimes to a level which can lead to the strangulation of the business.

In practice factors and invoice discounters can earn good fees out of these types of situations since many charge high rates for forwarding funds by TT, which a business that is short of cash may be forced to pay.

Most invoice discounting and factoring arrangements also have a built-in scale of charges to cover 'collect out' situations where they have to recover their money from a business's debtors following its failure.

In reality this means that a lender's exposure will often be limited by the time a business finally shuts down because they have successfully restricted drawdown. Meanwhile the failure itself then gives the lender scope to recover their collect out charges which can be highly remunerative.

So it is important to ensure that your business not only has sufficient cash available for its present needs, but has sufficiently flexible facilities to meet its future needs as it grows and in the next article in this series looks at how this type of funding works.


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Mark Blayney specialises in raising funding for owner managed businesses. For more information in plain English on factoring and invoice discounting or any aspect of business loans contact him at:
http://www.business-loans-info.co.uk