Minimizing Top 5 Risks of Invoice Factoring

With the financial conduct authority tightening criteria around business loans and other forms of business finance in recent years, many businesses have sought alternative sources of funding. One area of significant growth has been the use of finance solutions, by way of invoice finance, to liberate working capital from the receivables ledger.

The two main types of invoice financing are invoice factoring and invoice discounting.

In this article, we look at the potential risks from factoring your receivables ledger and how you can achieve a similar result while minimising the potential risks.

How invoice finance improves cash flow

Invoice finance allows businesses to extract working capital from unpaid invoices on the sales ledger. Every business needs reliable cash flow, or else they face insolvency. By bringing cash in before customers pay their invoices, a business improves both cash flow and working capital, proportional to the value of the unpaid invoices.

Invoice finance offers a shortcut to achieving a consistent improvement in cash flow, without waiting for their accounts receivable team to bring the cash in.

By using the value of outstanding invoices to secure funding proportional to the remaining balance of the receivables ledger, invoice finance provides business owners with an alternative to relying on bank loans or overdrafts to meet demands on cash flow.

What is invoice factoring?

Factoring allows businesses to fund cash flow by selling their invoices to a third party (a bank or independent finance provider) at a discount. The third party that provides the factoring is then responsible for the invoicing and collections process.

Invoice factoring can provide sellers with a much-needed injection of cash from the moment they sell their invoices to the factoring company. However, the provider deducts a percentage of the total invoice value as a service charge to cover the work and risk involved in owning the invoicing and collections process.

Invoice factoring risk #1: loss of control

Handing over ownership and responsibility for anything to an outside agency can be difficult for some businesses. Outsourcing something as sensitive as invoicing and cash collection can prove to be even less comfortable.

The factoring company will assume responsibility for all communications in the invoicing and collections process. As a result, a business’ existing customers may receive more demanding notifications than they are used to.

The average length of a factoring service contract averages between one and three years. Customer relationships may suffer in the long term when the focus shifts to bringing the cash in for the term of the ledger, rather than on maintaining good customer service.

Invoice factoring risk #2: recourse

Factoring comes in two flavours: recourse and non-recourse.

Recourse factoring means that the ultimate responsibility for invoice payment rests with the seller; the factoring company purchases the invoice on the understanding it will be paid. If a buyer does not pay within a specified timeframe, the factoring company has the right to demand full payment of the invoice amount plus the service charge for factoring from the seller.

Non-recourse factoring means the seller has no ultimate responsibility for payment of the invoices factored. Not all invoice factoring companies will offer this option to all of their clients. Due to the higher risk, non-recourse agreements are priced higher and may come with additional stipulations, such as reduction in credit limits or eligibility of only a percentage of the ledger.

Non-recourse factoring inherently provides bad debt protection as well as peace of mind that there will be no extra factoring fees or service fees to pay.

However, the cost of non-recourse factoring will depend on the perceived risk of non-payment and difficulty in extracting timely payments, which can be prohibitively expensive for a business used to late payments.

Invoice factoring risk #3: customer perception

When a business engages a factoring company, buyers are normally able to see this change, in the source and style of the communications as well as bank details or other changes to payment requirements. Bringing in a third party to handle debt factoring may give the impression of cash flow challenges, which can negatively impact the overall perception of your business.

A negative impact on sales results if buyers don’t feel comfortable maintaining a commercial relationship with a business they perceive to be struggling with cash flow.

As mentioned earlier, factoring may also impact the rapport with your customers that you have worked long and hard to build. The factoring company’s expertise is in managing cash flow challenges by collecting outstanding invoices, not in facilitating the customer experience. Long-term customer relationships are put at risk by negative customer experiences.

Invoice factoring risk #4: sales impact

No aspect of business cash flow exists in isolation. Working with a factoring company is likely to require steps to limit credit and collections risks, such as reducing credit limits and payment timeframes on some accounts. This, in turn, may hamper your sales team’s ability to sell into accounts who need longer payment terms and higher credit limits to do business.

Factoring providers may also stipulate that certain, higher risk regions or accounts fall outside of what they are prepared to take on. This could leave you with a need to maintain accounts receivables processes to service these accounts where credit score and creditworthiness do not meet requirements. It’s likely that these are exactly the sorts of accounts which you wanted to factor in the first place.

The caveats and restrictions of your factoring agreement may well impact your sales team’s ability to sell effectively, balancing acceptable risk for reward. Factoring companies are likely to want to play it safer by introducing stricter credit limits and other conditions on sales.

Invoice factoring risk #5: commitment

Long, fixed contracts can be costly and offer limited scope for change if customer relationships are negatively impacted by changes to credit and collections processes.

Factoring companies sometimes insist on the full leger. However, providers may choose not to take on the most challenging parts, which are the parts you most likely want to be covered. Even a single invoice that doesn’t meet the criteria set by the invoice factoring company can leave you needing to service this part of the ledger while the rest is covered by the invoice factoring work.

How to mitigate the risks associated with invoice finance

The majority of the risks outlined above lie in the fact that factoring operates at a significant remove from your normal accounts receivable processes. An alternative solution is to work with a managed accounts receivable provider, such as the Managed AR solution offering from Corcentric.

Managed AR provides many of the benefits of an invoice factoring service but operates as an extension of your business, for any type of business. Customers are treated with the same care and attention and receive communications as if they were directly from your business.

Furthermore, Managed AR is delivered in a way that supports your sales team’s need to offer generous credit terms and lengthy payment timeframes. Managed AR enhances existing processes, rather than placing limits on them.

Managed AR is non-recourse by default, removing the risk of extra costs from unpaid invoices in the future.

Managed AR can liberate working capital through setting DSO to just 15 days. Discover how by watching our 25-minute webinar.

Read this case study to learn how Daimler worked with Corcentric to drive their DSO down from 37 days to 15.