- 15 Jul
How Factoring & Invoice Discounting Companies Calculate The Initial Payment Percentage (Discount Percentage)
A question was posted on the UK Invoice Finance Research Group (LinkedIn) site asking how invoice finance companies calculate the discount percentage or the initial payment percentage (early payment percentage means the same thing) that they are prepared to fund against invoices. I though I would put my thoughts on this up on the blog in case others have similar questions.
Just to clarify the terminology, the full value of a sales invoice is obviously 100% and typically initial payments can be any percentage up to that figure (in rare cases funding can even exceed the value of the invoices if an overpayment is made). The way the initial percentage works is that if an invoice is worth £100 and the factoring company offers 80% funding the client receives £80 immediately (bear in mind there may be some other restriction applied in some cases), and when the invoice is paid the remaining £20 is passed on although charges are of course deducted. The initial payment being less that the full 100% value is what gives rise to the term "discount" hence discount percentage can mean the difference between 100% and the intial payment percentage (not to be confused with the alternative use of the term "discount" charge that means the cost of the funds charged over bank base rate or LIBOR!).
The following factors normally affect the calculation of the initial payment percentage by an invoice finance company, the amount of the reductions will vary between providers:
- Dilutions - anything that can reduce the value of the sales invoice that is paid. These could include: credit notes, disputes, offsets, contra trading accounts (balance on sales and purchase ledger), discounts offered, sale or return or other contractual issues that might dilute the value of the debt.
- Debtor/customer quality - if the quality of the client's debtors is high the invoice finance company will be more confident in their ability to pay the invoices and hence may fund more. The converse is of course also true so poor debtor quality may be reflected in a reduction in the intial payment percentage.
- Sector or industry - this can also drive the intial payment percentage, invoice finance companies are very experienced at working within a wide range of industry sectors so they will know which sectors typically give rise to payment issues and they may adjust the initial payment percentage accordingly.
- Debtor spread - a narrow spread of customers is less attractive to the invoice finance company, sometimes other methods of controlling prime debtors or concentrations may be used, such as a prime debtor restriction. However, the finance company may also adjust the intial payment percentage to account for this.
- The ageing of the client's sales ledger - if invoices are tending to become very overdue the invoice finance company may reduce the initial payment percentage.
- Financial stability and track record of the client - if the client has financial problems the invoice finance company may reflect this perceived increase in risk by reducing the intial payment percentage. It is also common practice that reductions in initial payment percentages may be used where clients are not compliant with covenants or conditions that have been placed on the facility.
- Audit trail - the audit trail is the paper trail that follows an order through to delivery, invoicing and then payment. If the paper trail isn't up to scratch the invoice finance company may reduce the initial payment percentage.
Those are the key factors that will affect the calculation of the initial payment percentage by an invoice finance company, the percentage is set at the outset of the arrangement but can be adjusted at any point. Different invoice finance companies will take different approaches to setting initial payment percentages so if you are having funding problems we may be able to find you an alternative invoice finance company that may take a different view in calculating the initial payment percentage.