Avoiding The Pitfalls Of Entering Into A Factoring Agreement
This article sets out a number of the common pitfalls that businesses can encounter when they enter into a factoring agreement to improve the cash flow of their business. It also seeks to give some helpful tips as to how you can avoid these pitfalls when you enter into a factoring agreement. You can also read our article about alternatives to factoring.
1. Miss Use of The Funds Raised Through The Factoring Agreement
The way that factoring works is that the business receives a pre-payment against the value of it's outstanding sales invoices. The value of these invoices is the working capital of the business i.e. the funds that need to be used to pay suppliers, staff, expenses etc. One common misuse of factoring is that a company will take the initial payment received from the factoring company, which can be substantial, and use the money for some kind of capital expenditure such as the purchase of equipment or machinery. The effect of this is that a large amount of the working capital within the business is then tied up.
THE ANSWER: The funds released through a factoring facility should be used as working capital within the business, if the business needs to raise finance to buy equipment or machinery, asset based finance (leasing, hire purchase etc) that are more suited to this kind of expenditure and will have a much reduced impact on working capital.
2. High Costs of Factoring
As with any finance there is a cost associated with accessing the funding and the facilities of some factoring companies are expensive, particularly when compared with their competitors.
THE ANSWER: If the business shopped around and seeks a number of different quotations, it is possible to find some very reasonable deals, it is just a case of knowing where to look!
3. Choosing The Wrong Factoring Company
It may appear that there will be no difference between factoring companies. Many people see factoring in a similar way to how they see their mortgage, once the finance is in place then it just ticks along in the background having very little impact on them. This is not the case for factoring. The factoring company has a close and ongoing relationship with your business in that they are providing a collection service in respect of your outstanding sales invoices. This means that the factoring company also has interaction with your customers. For this reason, it is highly important to choose a company that can provide a professional yet effective credit control service that will suit your business.
THE ANSWER: Once again, it is a case of looking around to find a factoring company whose style best suits your business rather than just choosing the cheapest quotation you can find. We can advise you about this.
4. Hidden Factoring Charges
We often speak to prospective clients that are dissatisfied with their current factoring company because they feel that the company have levied all sorts of hidden charges, which have pushed up the cost.
THE ANSWER: Before entering into a factoring agreement, you should ask the factoring company to provide a full statement of any additional charges that could be incurred so that you can be fully aware of the costs that you will incur for additional services if you require them. Once again, we can help you find the right pricing structure for you, even deals with no additional charges at all.
5. Leaving Things Too Late
The stronger the position of your business, the better the deal will be that you can command from a factoring company. If you wait until your company is in dire straits, the factoring company will seek to charge a fee that they feel reflects the additional risk they are taking.
THE ANSWER: If you plan ahead and arrange your factoring agreement before you get into cash flow difficulties you will be in a much stronger negotiating position in respect of rates and terms.
6. Overstating Your Financial Projections
Another common problem that we have seen is that a business will come up with a set of financial projections that are beyond what they are likely to be able to achieve. Often they hope that this will secure them a cheaper deal with the factoring company. If they then arrange their factoring agreement based on these projections, whilst the factoring company may give them a beneficial rate, that reflects the high level of turnover that they are projecting, they may also implement minimum fees that also reflect the high level of turnover. If the business then fails to achieve the turnover that has been projected they may still incur the minimum fee which is then disproportionate to the volume of trade.
THE ANSWER: The answer is simple, be realistic in the projections that you produce and on which the factoring agreement is costed and be clear about any minimums within your agreement.
7. Fresh Air Invoicing
The term "fresh air invoicing" means raising an invoice that does not have any underlying trading transaction i.e. no goods or services were delivered. Sometimes, when a business gets into difficulty, they may seek to raise some fresh air invoices in order to receive additional funding from the factoring company. In many cases, the client company only intends to do this for a short period of time whilst they overcome a short term problem, and in many cases they fully intend to repay the factoring company, at some point in the future. However, once they breach the terms of the factoring agreement in this way it often becomes difficult to repay the funding that has been raised and the company gets into more and more trouble and they resort to raising more and more fresh air invoicing in order to maintain their cash flow.
THE ANSWER: The answer is not to get into this situation in the first place. Many factoring companies will be sympathetic if they are approached for additional help when you are encountering a cash flow problem. In many cases, the factoring company will be prepared to provide additional funding in the form of, for example, a short term overpayment in order to see you through the problem.
Hopefully, being aware of the pitfalls of entering into a factoring agreement will help you to avoid them by following the suggestions given above. Factoring continues to be a very effective way of funding a growing business that is used by a large number of companies within the UK.