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FACTORING AND INVOICE

The areas discussed in this article are from study company, its history, and, most importantly, the
sessions 28 (c), (d) and (e) of the Syllabus. In these quality of the company’s credit customers.
sessions, it states that students must be able to: Students are often under the misapprehension
(c) describe how factoring works and the main that factoring is a good way to recover monies
types of service provided by factors relating to debts that have been outstanding for
(d) define invoice discounting and outline how this some time and are now proving difficult to recover.
form of factoring works This is definitely not the case. A factor will review
(e) calculate the cost of factoring arrangements an applicant company’s sales ledger very carefully,
and invoice discounting. and if the factor thinks that any of the debts
are doubtful, it will exclude them from
Each of these syllabus requirements is discussed its initial prepayment and from its list of
in detail below. approved invoices for future advances.
Unlike invoice discounting, which is
STUDY SESSION (C) discussed later, factors are involved in
DESCRIBE HOW FACTORING WORKS AND the administration of the company’s sales
THE MAIN TYPES OF SERVICE PROVIDED BY ledger. Their involvement includes:
FACTORS
Students seem to get thoroughly confused between When an invoice is raised
invoice discounting, factoring, and offering The company raises invoices itself in the
discounts to customers. By giving a more detailed usual way and sends them to its customers. In
explanation of factoring arrangements, I hope addition to this, however, each time an invoice is
that students will at least remember the basics raised, a copy is also sent to the factor. The factor
for the exam. In this section of the article, the will then pay an agreed percentage of the invoice
organisation providing the factoring is referred to value to the company. It will also take on the credit
as ‘the factor’ and the company factoring its debts control function. This will include issuing statements
is referred to as ‘the company’. to the company’s customers and telephoning them
Factoring provides a form of advance against if necessary.
a company’s trade receivables. Instead of the
company having to wait for cash from its credit When the customer pays the invoice
customers, the factor agrees to pay for a proportion When a factoring agreement is in place, customers
of the debts upfront. Typically, a factor will must pay 100% of each invoice directly to the
pay up to 85% of approved invoices. Factors factor. Each invoice must clearly show the factor’s
may be independent organisations but are remittance details on it. Having received the
often subsidiaries of major banks or financial money, the factor will then deduct its fees, its
institutions. Whatever they are, one thing is for interest, and its advance from the remittance
sure. They will not want to pay out money that before paying the balance to the company.
they do not think they will get back. Hence,
they will want to closely examine the applicant Unpaid invoices
company, assessing the financial stability of the If an invoice remains unpaid for a certain period,
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as specified in the factoring agreement, the legal customers. It may then agree to advance a certain discounter. In this case, the amount to be repaid
position as regards who bears the loss depends percentage of the total outstanding sales ledger will therefore be $75,000.
on whether the factoring agreement was a ‘with value. In return, it will demand a monthly fee for One of the advantages of invoice discounting
recourse’ agreement or a ‘without recourse’ the service and interest on all amounts advanced. is that, because control of the sales ledger is
agreement. If it was a ‘with recourse’ agreement, retained by the company, customers do not
then the factor has recourse to the company for usually know about the invoice discounting
all the advanced debts. This means that it can arrangement. There can be a certain stigma
reclaim the money from the company. attached to factoring arrangements
In ‘without recourse’ or ‘non- since a company’s customers may
recourse’ factoring, the factor bears become concerned about the
the loss of bad debts. The company company’s financial stability
will still have to pay any fees and therefore its ability
and interest relating to the to meet its contractual
invoice. This is always the obligations. This doubt
case anyway, regardless of in the company
whether the agreement can be harmful
is with or without to its reputation
recourse. With non- and hence, to
recourse agreements, its likelihood
however, the factor of success.
will take over all With invoice
rights to pursue discounting,
the debt through on the other
the usual legal hand, the
channels. Hence, company
it becomes clear continues
that non‑recourse to collect its
factoring is not own debts
just an advance and perform
of monies and an its own
abdication of the credit control
function of credit functions.
control; it is also While the
a transfer of risk invoice
from the company discounter will be
to the factor. Because in the background,
of this, non-recourse checking regularly to
factoring will be significantly see that the company’s
more expensive than debt collection
recourse factoring. procedures are effective,
the company’s customers
STUDY SESSION (D) need know nothing about this.
DEFINE INVOICE DISCOUNTING As with factoring arrangements,
AND OUTLINE HOW THIS FORM OF invoice discounting arrangements can be
FACTORING WORKS with recourse or without recourse. The same
Invoice discounting is a different way of obtaining principles apply.
an advance on invoices, albeit not radically Probably the biggest misconception students
different. Many finance organisations actually offer Then, each month, money will either be repaid have as regards invoice discounting is the belief
the alternatives of factoring or invoice discounting. by the company to the invoice discounter, or the that it is a form of discount offered by a company
In this section of the article, the organisation invoice discounter will advance more money to the to its customers. Invoice discounting is in no way
providing the invoice discounting service will company. Which of these is the case depends on similar to offering an early settlement discount to
be referred to as the ‘invoice discounter’ and whether the total amount owing to the company by customers. It is a term with a specific meaning,
company requiring the service will be referred to as its credit customers has gone up or down. as detailed above.
‘the company’. For example, at the beginning of the invoice
With invoice discounting, an advance on discounting agreement, the invoice discounter STUDY SESSION (E)
invoices is paid by the invoice discounter in a may have paid 75% of the sales ledger value to CALCULATE THE COST OF FACTORING
similar way to an advance paid by a factor. A the customer. If the total amount outstanding ARRANGEMENTS, INVOICE DISCOUNTING AND
fundamental difference, however, is that with from receivables at this time was $1m, then the CHANGES IN CREDIT POLICY
invoice discounting, the company retains control invoice discounter would have paid $750,000 to When calculating the costs of factoring or invoice
over the administration of its sales ledger. the company. If, one month later, the total value discounting arrangements, there will be two
As with factoring, the invoice discounter on the sales ledger has fallen by $100,000 to main costs involved – interest and fees. Typical
will firstly perform rigid checks on the company, $900,000, the company will have to repay 75% interest charges range from 1.5% to 3% over
assessing its credit history, its systems, and its of that decrease of $100,000 back to the invoice base rate. As regards charges, there will be an
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administration fee for both invoice discounting – An estimated reduction in accounts above, only this time a figure of 40 is used rather
and factoring. However, since factoring also receivable days to 35. than 35 to reflect the slower debt collection period
involves the factor performing the credit control – An annual administration fee of 1.3% without a factor. Having performed this calculation,
function for the company, its fee will also involve of turnover. the cost of financing receivables by overdraft
a charge for credit management. Typically then, – Interest charge on advances of 12% can be calculated by applying the overdraft rate
a factor will charge fees ranging from 0.75% to per annum. of 10% to this figure. Finally, include the credit
2.5% of turnover. An invoice discounter, on the 4 Current overdraft rates are 10% per annum. controller costs of $30,000 and the sales ledger
other hand, will usually charge from 0.2% to 5 Assume there are 365 days in a year. clerk costs of $17,000. Your answer should then
0.5% of turnover. look like this:
In non-recourse agreements, there will also be Calculate whether it is financially beneficial
a credit protection charge, whereby the factor or for Waste Co to factor its accounts receivables Accounts receivable reduced to 40 days:
invoice discounter reflects the cost of bearing the for the next year, as compared to employing a $3,187,500 x 40/365 $349,315
risk of bad debts. The charge depends on the level credit controller.
of risk assessed by the factor/invoice discounter, $
but will typically be from 0.5% to 2% of turnover. When answering this type of question, the best Overdraft cost
This all looks fairly straightforward as approach is to have two distinct calculations – one $349,315 x 10% 34,932
regards calculating the cost of factoring or which calculates the cost of factoring and one Credit controller costs 47,000
invoice discounting, but what makes exam which calculates the cost without factoring. Then, 81,932
questions more difficult is the fact that, in real the difference between the two calculations will be
life, there will often be a change in the sales the cost/benefit of factoring. Since the cost of factoring is $5,039 less than the
level from one year to the next. Also, by using cost of not factoring, your answer should state that
the services of a factor, a company’s receivables Cost of factoring it is financially beneficial to employ the services of
days may be reduced. Both of these aspects The first calculation that needs to be made is of a factor.
need to be incorporated into calculations. Finally, the new sales level for the coming year. Since sales
if a factor is used, the company may save on are expected to increase by 25%, just take the SUMMARY
the salary of a credit controller, for example. current sales level and multiply by 125%. Having This article aims to improve students’
Let us refer to the question in the December done this, a new receivable days calculation can understanding of some of the key areas in Paper 10
2007 exam as an example. Extracts from it are be performed by taking the new sales figure, that have been poorly answered over recent
detailed below. dividing it by 365 days and multiplying it by the sittings. The level of detail given about factoring
new receivables days of 35. It will be this figure and invoice discounting goes beyond what students
Waste Co is a waste management company, with that forms the basis for calculating the interest would be expected to produce in the exam. I hope,
one sole shareholder/director, Mr Trusty. It collects on the amount advanced by the factor: take the however, that this background knowledge will
two types of waste from businesses – recyclable receivables amount and multiply both by the enhance students’ understanding of these areas
waste and confidential waste. Since companies amount advanced by the factor and the interest so that they remember enough of the basics to
have increasingly become aware of both the need rate charged by the factor. Similarly, the amount produce better answers in future exams.
for recycling and the need to protect confidential not advanced by the factor will give rise to bank
information, Waste Co’s client base has expanded interest, so this remainder needs to be multiplied Ann Irons is examiner for CAT Paper 10
rapidly over the past two years. by the current overdraft interest rate. Finally, don’t
As the business has expanded, Mr Trusty forget the administration fee of 1.3%. This
has had less time available to focus on needs to be applied to the whole turnover figure.
credit control. This has resulted in a steady Students often mistakenly apply this percentage to
deterioration in accounts receivable collection the receivables figure. Hence, your calculation for
and a rapid increase in Mr Trusty’s overdraft, the cost of factoring should be this:
despite high profits. Mr Trusty’s bank has now
refused to extend his overdraft any further and New sales level =
has suggested that he either employ a credit $2,550,000 x 125% $3,187,500
controller or factor his accounts receivable. Accounts receivable reduced
The following information is available: to 35 days:
1 Credit sales for the year ending 30 November $3,187,500 x 35/365 $305,651
2007 were $2,550,000, and average
accounts receivable days were 60. Sales $
are expected to increase by 25% over the 80% advanced by factor at 12%:
next year. $305,651 x 80% x 12% 29,342
2 If Mr Trusty employs a good credit controller, 20% still financed by overdraft:
the cost to the business will be $47,000 per $305,651 x 20% x 10% 6,113
annum. It is anticipated that the accounts Admin fee: $3,187,500 x 1.3% 41,438
receivable days can then be reduced to 40. 76,893
3 A local factoring organisation has offered to
factor the company’s accounts receivable on Cost of not factoring
the following terms: In order to calculate the costs without factoring,
– An advance of 80% of the value of another receivables level, still based on the
sales invoices (which Mr Trusty would increased turnover figure calculated above, needs
fully utilise). to be calculated. The process will be the same as