Types Of Factoring
"Factoring" is often used as a global term to describe a collection of business finance products that would be better described as "invoice finance" or "receivables finance". It is really a subset of the receivables finance product range, which is the umbrella term for these working capital, cash flow enhancing products. However, there are also a number of different types of factoring, each of which is explained below in this article.
If you are considering using any of these financial services, you should read this guide before making any decisions.
These services are normally offered by specialist finance companies and banks, which are known within our industry as "factors".
Supply Chain Finance
In some cases a large supplier may offer a similar kind of service to their suppliers (often with the actual service provided by a factor), this is known as reverse factoring or supply chain finance. The benefit of this approach is that the smaller suppliers can access lower rates that would normally only be offered to their larger customer.
Mathematical Usage Of The Term
In this article all references relate to the financial use of the term. The other use is in the mathematical sense, and more information, and helpful resources, can be found in our section about factorization of numbers.
Financial Definition Of Factoring
Before describing the various types of product, we will start with our definition, for the financial use of the term:
"Factoring is the provision of a credit control service to handle the collection of unpaid sales invoices, which are assigned to the factor who may also provide the option of receiving prepayments against the unpaid receivables."
This is only one of many definitions. You will see other definitions on the Internet, about it being the "sale of invoices at a discount", this is equally true, but few understand what this means. Our definition explains exactly what the service does, in layman's terms.
The reason for the focus on the credit control service, within our definition. is that service only factoring does not include the provision of funding, the customer only received the credit control service. They may, or may not still assign their invoices. This is rare in the UK, but should be noted as a possible exception. Outsourcing of credit control generally is much more common, but would not necessarily be promoted under this particular product name.
Different Types Of Factoring
Recourse Versus Non Recourse
There are a number of variations on a theme when you categorise these products. Firstly, you can split the products between recourse and non recourse, the differences are explained below:
With recourse factoring you receive finance (prepayments) against your unpaid credit invoices. You also receive a credit control service from the factor although the extent of this service can vary greatly between providers. It can be partial chasing of the largest few customers, or comprehensive management of your entire sales ledger such that you don't need to have any credit controllers employed by your business - this can create a significant cost benefit.
By the term recourse, it means that the factor will have recourse to you, to recover the prepayment, if the invoice is not paid within an agreed period. This period is called the recourse period e.g. 90 days from the end of the month in which the invoices was raised.
You will find a detailed explanation and example of how recourse works, on our blog.
The alternative is "non recourse". This provides the same services and benefits as recourse, but the factor will NOT have recourse to you to recover the prepayments. If the invoices are not paid, providing you traded within agreed credit limits for each of your debtors (these are set by the finance company who will undertake the credit research on your customers for you) you will not have to repay the prepayments. This provides you with bad debt protection. Furthermore, after an agreed credit period, the factor will credit you with the balance of the invoice value (after deduction of charges, and less any first loss clause). This is called the credit period.
This type of facility can give you more peace of mind if you are worried about your customer's failing. It does not protect you against disputes though.
Non recourse, for whole turnover facilities (where all your invoices are factored), is often referred to as "full factoring", within the industry.
Selective Versus Whole Turnover
You can also split these products according to the requirement to factor either selected invoices (selective or spot), or all your invoices (wholeturnover).
Spot Or Selective
These facilities are similar (unless selective is used to describe a discounting product i.e. a service that does not include credit control). You choose which invoices to submit to the factor for funding and collection, with both selective and spot. Typically there are no minimums or lock ins that require you to keep using the facility. However, if used regularly this can be a costly method when compared with whole turnover. However, if you only want to dip into the finance occasionally, or you want a facility "in case of need" this can be a very flexible option.
Recently, there have been a large number of small, new entrants into the selective market space. Our research suggests that c.37% of businesses would choose the selective route, rather than seeking funding against their entire sale ledger. Most want to raise the maximum amount of money to improve their cash flow.
As the name suggests you factor all of your invoices, but there are some exceptions. Many factors will agree to (or in some cases insist on) excluding certain debtors, or types of sale - if required. The approach is often more flexible than the name suggests. One of the key benefits is the bulk discount in pricing due to all your transactions being put through the facility. If you intend to use this kind of finance regularly, funding against your whole sales ledger and turnover, is likely to be the most cost effective approach.
You will rarely hear people referring to "whole turnover" as a product name as it is generally assumed that this is what you are talking about, unless you define a product as selective, or spot.
Confidential Versus Disclosed
Another dimension by which you can categorise these products is whether they are "confidential" or "disclosed". This means whether or not the debtor is aware (disclosed) or not (confidential) of the facility.
The majority of factored invoices in the UK are factored on a disclosed basis. This means that the customer (your debtor) is aware of the involvement of the factor. They will be aware due to the following aspects of how the facility operates:
- Sales invoices - an "assignment clause" is required to be placed on all sales invoices. It discloses the arrangement and tells the debtor that the invoice has been assigned to a factor. Therefore they have to pay the factor in order to discharge their liability. Indeed, if they do not pay the factor, but pay the supplier instead, they can be legally asked to pay again. An example of an assignment clause would be: "This account has been purchased by and assigned to XYZ Factors Limited, to whom payment must be made to discharge your obligations." Additionally, they may include bank details for the payment to be sent to.
- General notice of assignment letter (GNA) or Notice of assignment (NOA) - it is common to provide customers with a general notice of assignment letter, at the outset of the arrangement. This has exactly the same function as the assignment clause, notifying them of the arrangement, and the fact that the sales invoices have now been assigned to another party.
- Account statements and invoice collections letters - these will be received from the factor, bearing their details and name, as they are handling the credit control function.
- Collections calls - as the financier is undertaking the credit control function, it will be their staff that will call your debtors, using the name of their business.
Confidential - Non-Notification
The alternative to disclosed, is "confidential", sometimes called "non-notification factoring". This is not so widely used in the UK, but is available from a small number of specialist providers.
In short, the factor provides the credit control service, and sends out the statements and chasing letters. However, all of this is done in the name, and sometimes branding, of their client. The objective is that the debtors don't even know that the factor is involved. They may use dedicated telephone numbers, answered in the business name of their client, so that debtors can call them about their accounts receivable.
Payments will be made into a bank account, set up and controlled by the factor, but in the name of their client. So to your debtors it will appear that they are paying into your bank account, rather than a trust account.
With confidential products, general notice of assignment letters are not sent at the outset, and assignment clauses are not placed on invoices. However, the funder will normally require that they hold a supply of GNA letters, in case they have to collect out the ledger and disclose their position. This would only happen in situations such as you breached the facility. They will have the right, built into the contractual agreement, to disclose to your customers should they need to.
Domestic And Or Export
These services can be offered in respect of just UK customers (domestic), just export customers (overseas) or a mixture of both.
Export Or International
The service can be offered to exporters. There are various different ways of handling the export or international factoring element. It can either be a case of the factor handling the collections themselves, from the UK (sometimes called "direct"). Alternatively they may use a network of correspondent factors abroad (sometimes called "indirect"), such as Factors Chain International (FCI), to handle that task for them (the UK factor will reciprocate for the counterparty's clients in the UK).
Import factoring is the term for a UK factor handling the UK credit control for an overseas client. This may be through dealing directly with the client or via reciprocation for an overseas factor, as mentioned in the previous paragraph. The overseas supplier will ship goods and raise invoices on the UK debtor, that invoice will then be passed to the UK factor for them to collect the debt in the UK. Often this type of counterparty arrangement works well, as it overcomes the need to have staff with foreign language skills and knowledge of the local customs of foreign countries.
Using this type of service gives the supplier the opportunity to offer their buyers short-term credit for goods, trading on open account terms, without the need to issue any kind of banker's guarantee, letter of credit or bill of exchange.
Invoice Discounting And Invoice Finance
Invoice finance is the umbrella term for all receivables financing products. It can be defined as "providing funding against unpaid sales invoices" although that doesn't quite capture service only as mentioned above. Under that umbrella comes factored services (finance with a collections service), and invoice discounting (finance only). In simple terms that is the hierarchy of products such that we would not consider invoice discounting or invoice finance to be considered types of factoring. This is contrary to many definitions that you may read on the Internet.
CHOCs or CHOCCs (Customer Handles Own Collections or Customer Handles Own Credit Control) is another form of invoice discounting where the involvement of the discounter is disclosed, but the customer is allowed to handle their own credit control activity. Again this is really a type of discounting, but people often interchange the terms.
Differences Between Providers, Facilities And Product Brands
It would not really be correct to categorise them as different types of product, but there are dramatic differences between the products offered by different finance companies, under the same generic product names. This can be differences in terms of:
- Service levels and approach.
- Pricing - we identified a 49% differential between the cheapest and most expensive.
- Funding levels.
- Risk appetite.
- Structure e.g. location of the financier.
These differences are described in detail, in our article: The 5 Key Differences Between Factors.
It is also the case that some providers will give their products, brand names. Whilst these may appear to create even more types, the products can normally be broken down into the categories that have been described above by virtue of the functions and services that the product provides.
Add Ons And Sector Specialisation
There are a number of additional add ons, and also some products that are tailored to particular industry sectors.
This bolts on the management of the client's payroll, to the facility. The factor, or an payroll management company that they use, takes over handling the customer's payroll. They will raise all the paperwork, payslips, P60s etc. This is often attractive to sectors that have a lot of staff to manage, perhaps where wages are a large chunk of their costs e.g. the temporary staff recruitment sector.
For importers trade finance enables them to pay their suppliers for imported goods, and enjoy a period of credit before they have to repay the finance. This allows them to sell and get paid for the goods that they are importing, before they have to pay their suppliers. Trade finance can be a standalone facility, or it can work in conjunction with factoring to offer the client an even longer period of credit. When the two are coupled together, the factor collects in the end customer payments, in respect of outstanding invoices, and uses part of that money to repay the trade finance - a very neat solution that allows an importer to enjoy an extended period of credit.
Bad Debt Protection
This is an alternative term for non recourse, which was described above. This is often considered an add on to a facility, and a separate additional charge or CPE (credit protection element) is levied for the additional service. In some cases however, the charging is a single combined fee, without it being separated.
The construction sector tends to operate in a slightly different way to other industry sectors. Firstly it is highly contractual, but secondly suppliers tend to raise what is called an "application for payment", rather than an invoice (about 75% according to our research). In light of this, a number of factors now handle the sector, using specialist construction sector finance facilities.
Vehicle Crash Repairs
Another sector specific offering is for the vehicle crash repairs sector (body shops). As the ultimate debtor tends to be an insurance company (which are often creditworthy but may take time to pay), and there is a clear paper trail evidencing the debt, some specialist finance companies will offer up to 100% funding (less charges) against bodyshop invoices.
So there are numerous different types of service, many of which can be combined to create quite a number of different product variations:
- Recourse or non recourse.
- Confidential or disclosed.
- Selective (also called spot) or whole turnover.
- Export and or domestic (UK).
- Service only (without funding).
- Add ons and sector specific offerings.
There are also the many variations between factors in terms of delivery, service levels etc. If you are thinking of using any of these products it is probably wise to seek some advice, from a firm of business finance brokers, about the various different types of factoring.