Although the terms "Invoice Discounting" and "Invoice Factoring" are often used interchangeably, we regard it as two closely aligned financing products.
In terms of "Invoice Factoring", a business would typically have a good spread of clients of varying sizes, in various industries, with good payment histories. We provide an ongoing facility against this debtors book, which is based on our assessment of the book's credit standing, the client's own trading history and its balance sheet.
Although we confirm invoices with the debtors, we do not require payment undertakings from them. Depending on the circumstances, we may take over the collection of the client's book.
This product therefore suits a stronger business with a good spread of debtors, instead of a few larger debtors.
Invoice factoring is a particular form of invoice finance.
The financier takes the invoices issued by the business to its debtors as security. In invoice factoring, the financier would typically want to see a debtors book made up of many, smaller debtors instead of a few large debtors.
The credit risk would therefore be spread amongst many debtors and the history of managing the debtors book becomes an important factor for the financier.
In many cases, the financier will take over the management of the debtors book on behalf of the business.
In some cases the financier will allow the business to continue managing the debtors, i.e. when the business has a long trading history, a strong balance sheet and a successful collection record.
Invoice factoring is offered by a few specialist financiers and some banks in South Africa. It is a way of raising business finance by factoring business debtors to a financier. Invoice factoring has been available in South Africa for many years.
A small business with cash flow problems can use invoice factoring to convert debtors into cash. Invoice factoring allows the small business to effectively raise money against its debtors.
The business will need a strong debtors book, i.e. a good spread of small debtors or a few large debtors with good credit standings.
In many cases a small business’s working capital is locked up in its debtors. Invoice factoring frees up the working capital and provides cash to the business which will help it to continue growing.
Invoice factoring costs typically vary between about 3% and 7% per month.
In some cases the quoted monthly costs could be lower, but the financier may then charge a collection cost (say 2% of all outstanding debtors) which should also be taken into account when comparing costs.
Sometimes the costs are fixed for a month, e.g. the cost would be 5% irrespective of the actual time it takes before the debtor pays.
In some cases the costs are calculated on the full amount of the invoice and in other cases the costs are calculated only on the portion which is actually advanced to the client.
Sometimes a minimum monthly fee is charged even if no debtors are factored during that month.
Small businesses which are considering invoice factoring should ensure that they understand exactly how and when fees are charged and calculated by potential financiers so that they can make informed decisions.
The major benefit of invoice factoring is that an asset on the balance sheet which is sometimes overlooked, i.e. the debtors, can be used to raise finance.
This is especially true if banks are not interested in funding the business because they see it as “too risky”.
In some cases the business may also want to outsource the management of its debtors book to a professional outfit such as a factoring house. Although this usually not cheaper than managing the debtors in-house, it may be more efficient.
The business must have debtors.
Credit terms for payment should only be extended to clients of the business after an acceptable process of determining credit risk.
The risk in the debtors book as a whole must be acceptable to the financier.
Factoring is a form of business finance provided by specialist financiers. The financier will advance an amount normally expressed as a percentage of the total debtors book, for example 60% of all debtors below 60 days.
In some countries the term “factoring” is also used for invoice discounting, where only certain large debtors are used as security to raise finance.
In invoice discounting a larger percentage, up to 80% or even 90% of the amount outstanding can be financed.
The actual percentage advanced would normally depend on the debtors book, the credit period and the credit risk associated with the debtor.
This depends on the legal structure used to raise finance against a business’s debtors, not the terminology.
If the debtors, or more specifically their obligations to make payment in terms of the invoices, are sold to the financier, it is legally considered to be a sale and purchase and not a loan or a debt.
If the debtors are only used as security for finance, it is legally regarded as debt.
However, these general statements may be overridden by accounting regulations or legislation applicable in a particular country.
Whether or not the financier has recourse to the business if the debtors don’t pay also plays a role in determining how the transaction should be seen.
The legal nature of the transaction may be entirely different from the accounting treatment of that transaction, which may also be different to the tax treatment, e.g. for income tax and VAT purposes.
From a business management perspective, our view is that factoring should be regarded as a way of raising working capital at a certain cost and should therefore be regarded as debt, irrespective of the legal, accounting or tax status of the transaction.
There are probably as many types of factoring available as there are factoring companies, because it seems that almost each factoring house’s product is slightly different from the others.
In South Africa, factoring is usually based on the entire debtors book while invoice discounting is based on certain larger debtors, sometimes even only a few selected invoices.
In some cases the debtors are aware of the factoring, in other cases not.
In some cases the debtors actually co-operate to assist their supplier to raise finance, in other cases not.
Sometimes the financier takes over the management of the debtors on behalf of the client.
The best solution ultimately depends on the products offered by the financier and whether they address the needs of the client.
Doctor Jones recently started a new dental practice. To accommodate some of his patients, he allows them to pay their bills within 30 days from the treatment. However he needs better cash flow to pay his staff, equipment and rental. A factoring house advances 60% of the outstanding debtors book to him.
Builder’s Supplies sells building materials to many smaller builders on credit. To increase the stock to grow the business, Builder’s Supplies need more working capital. By factoring its debtors it can raise more cash, increase its stock and keep growing the business.
Invoice finance means u sing a business’s debtors as security to raise finance.
It has the same meaning as “debtors’ finance” and can take many different forms, such as factoring, reverse factoring, disclosed invoice discounting, confidential discounting, non-recourse discounting etc.
Which method of invoice finance would be best for a particular business depends on a wide range of factors, such as the circumstances and needs of the business itself, its debtors, the relationship between the business and its debtors and the requirements of the financier.
Invoice finance is offered by several specialist financiers and banks in South Africa.
Invoice finance itself is a very broad term. Each specialist financier has a slightly different approach to invoice finance and may therefore offer a product which could differ substantially from those offered by other financiers.
A business which needs invoice finance should shop around until it finds an invoice finance product which suits its own circumstances and needs.
A small business often has cash flow problems.
The main cause for the cash flow problems is usually that a small business has to pay its suppliers cash on delivery, while its large clients demand lengthy credit terms. This means that the small business’s working capital is used to fund its debtors. If the small business grows, it will run out of working capital soon.
Invoice finance can be used to convert its debtors into cash. This allows the small business to continue paying its suppliers. If it can’t pay the suppliers, the doors will have to close.
Having a positive cash flow is essential for the growth of any small business.
Any business with debtors on its balance sheet should consider invoice finance. The debtors book is an asset on its balance sheet and could be used as security for raising finance for the business.
It is a quick and simple method of raising finance, especially when bank facilities are not available or fully utilised.
Invoice finance is generally more expensive than normal commercial bank funding. Invoice finance is much more complicated and requires more administration than a bank’s term loan. It is also usually more risky for the financier.
The cost of invoice finance should not be compared to bank funding if that is not available. A better comparison is to ask: what discount would the business give to its debtors for early payment? Such a discount could typically range between 3% and 7% per month.
John’s Trucking is a small business with a variety of debtors. John’s Trucking needs cash to pay for its diesel supplies but the debtors cannot pay earlier.
John approaches a financier who agrees to advance cash in advance, based on the business using the debtors as security. Every month the financier considers the debtors book and pays John’s Trucking an amount of cash in advance. This allows John to pay for his diesel upfront.
Invoice finance is a general term meaning the use of a business’s debtors or invoices as security to raise finance.
Factoring is a particular form of invoice finance. It typically means that the financier considers the whole debtors book as security, instead of particular debtors.
Ideally the financier wants a good spread of debtors, with little concentration risk. The more debtors there are, and the smaller they are, the better.
To limit its own risks, the financier may want to take over the management of the debtors on behalf of the business.