When small businesses foresee an increase in their expenses, they turn to a third-party financial institution and enter an agreement where they sell their invoices and get a percentage of the invoice value quickly.
This agreement is known as a factoring agreement.
Factoring Agreement
When a factoring institution and a company decide to begin the process of invoice factoring, they decide on an agreement.
A factoring agreement is a financial contract or arrangement that lists the terms of purchasing a company’s outstanding invoices (accounts receivable) and the total costs.
Factoring agreements will generally cover the costs associated with factoring services, maintenance, and termination fees.
They also cover legal consequences that bind the parties to a factoring agreement, such as financial penalties or disputes.
Parties of a Factoring Agreement
In a factoring agreement, there are three parties involved:
The business selling its outstanding invoices or accounts receivable
The factor or a company that provides factoring services
The company’s client who is responsible for paying the invoice amount to the factor
The Standard Factoring Agreement Process
The first step in invoice factoring, a company needs to be in business with a factoring company. This enables the company to factor their accounts receivable whenever they need to.
The standard process of factoring is then -
A business’ clients requests goods or services from them
The business contacts its factor so they can begin the process of credit check and verification of the company’s client to ensure the qualification of the invoice
After approval from the factor, the company completes the business with its client
The company sells the approved invoice to its factor and receives a percentage of the total amount immediately
The factoring company then takes ownership of the invoice, handles the collection process from the company’s client, and transfers the rest of the money owed to the company after payment from the company’s client
Factoring Agreement Terms
Small businesses must be aware of these terms when entering a contract with a factoring company -
Notice of Agreement When a company signs a factoring agreement, the company gives the factor the right to collect the amount due that would otherwise be on the company to collect. The factor has a legal obligation to inform the company’s clients that the payments will be made directly to the factoring firm. This is known as a notice of agreement.
Invoice Changes Once the company sells its accounts receivable or outstanding invoice to a factoring company, it is obligated to add a notice on its client’s bill stating the invoices are sold, and the payments are to be made directly to the factor.
Any default payments made incorrectly to the small company after the invoice is sold to the factor, the amount received is to be sent to the factoring firm.
Any updates on the schedule applicable to the factor on the delivery of goods or services and amount changes of the invoice related to the company’s clients must be provided to the factoring company.
Customer Limit A factoring agreement has a total credit line lent to the small business from a factoring company. However, the factor would not want the company to tie up most of the cash in invoices from one customer.
For example, if a business is given a credit limit of ₹5,00,000 but a customer limit of ₹4,00,000, then the company can’t use the entire credit limit on an invoice from a single customer.
Only a certain percentage of the limit can come from an individual customer. The business must know this when establishing an agreement with the factoring company.
Non-Approved Accounts and Disputes
Before offering invoice factoring services, the factor needs to approve the customer’s request. This means that the customer should be deemed credit-worthy to the factor and does not have any risks associated with them.
As per the agreement, the factors have the liberty to convert an invoice account to a non-approved account if there are any disputes between the parties involved. Most factoring agreements extend a certain period for an account’s settlement before declaring it a non-approved account.
Minimum Annual or Sales Commission The minimum amount a small company needs to pay to the factor over a term, usually annually. A company should be cautious to check this part of the agreement because they might be liable to pay the factor without using their services.
Reserves Any amount paid by the company’s clients to the factor will be put in escrow in a reserve account. This will allow the company to track the invoices that have been paid, due, or the amount owed.
Warranties and Representations A factor will require assurance from the company to see whether it is operating legally and financially well and not to declare bankruptcy.
Statements must be made as part of the agreement, known as guarantors or representations that offer security against loss.
This is a clause to protect the factor from losses in case the company makes untrue statements.
Schedule of Accounts As a company would not factor all of its outstanding invoices, the factor expects the company to detail all the invoices they want factored.
Factoring Agreement Fees
When entering or exiting a contract with a factoring company, small businesses should be expected to pay a variety of fees.
- Origination/Draw Fees When drawing or issuing a factoring agreement, there is an upfront fee which is a flat rate a company needs to pay to the factor and is calculated on the company’s total facility amount.
For example, a company’s facility is ₹2,00,000, and the origination fee is 1%; a total of ₹2000 will be taken from the initial funding.
Factoring Fees The amount disbursed by the factor on the invoices purchased is provided at a discounted fee, which is a part of the factoring cost . Apart from this, a factor also subtracts his/her service charges and then lends the amount to the company.
Monthly/Weekly Fees Based on the factoring agreement, a company may need to pay off monthly or weekly fees for maintenance. This fee can vary depending on different factors, with various contracts levying different percentages on different periods.
Termination Fees If at any point a company decides to terminate or discontinue the agreement with the factoring company, they may be liable to pay a termination fee as agreed upon in the terms and conditions of the factoring agreement.
Factoring Arrangement Benefits And Drawbacks
There are certain advantages and disadvantages for a company looking into a factoring agreement; these are:
Advantages
Quick access to money for companies facing a crunch
Boosts the working capital of a company
Helps solve issues such as maintaining inventory or mitigating unexpected expenses
Disadvantages
Companies will have to cover factoring costs, legal fees, account maintenance, etc.
Revenues will be lower in long-term due to receiving liquidity upfront for factoring accounts receivable
The agreement can be complicated for a small company looking to factor its invoices, such as hidden charges
Important Things to Consider with Factoring Agreements
Like any contract, it is vital that companies know the various features of a factoring agreement and how it can impact the business. Certain things need to be considered with factoring agreements -
- Reading the contract thoroughly Every clause pertaining to a factoring contract is essential to know before entering the contract. Unexpected or hidden fees can be overlooked, which would eventually be a continually added cost for the company in the long run.
Reviewing the document thoroughly, therefore, is vital so that the company does not get bound to a complicated agreement costing them money.
- Researching the Factoring Company When the company has sold its invoices, the obligation or responsibility of collecting the payment shifts to the factor, meaning that the factor will be in direct contact with the company’s clients.
However, the way the factor collects the invoice amount from the client reflects directly on the company. This it is essential to conduct enough research before finalising your factoring company.
Comparing Fees A company should compare the different fees levied by different factoring companies to know which is most economical for the business to generate an inflow in their cash.
Comparing the Speed of Payment Factoring companies have different payment terms and will not pay the company the amount when they need it.
This is why it is crucial that the company reads and compares the payment terms carefully before entering into an agreement.
FAQs
Can you write off factoring fees?
Your trade debtors will continue to appear on your balance sheet as an asset if you enter an agreement with an invoice factoring facility. Any money withdrawn from the facility will appear on your balance sheet as a liability. Any costs associated with having a factoring facility for invoices will be subtracted from pre-tax earnings on your P&L.
Does factoring reduce profit?
Factoring has the drawback of lowering firms' overall profits. The factor will always want a percentage of the total invoice amount (often 1-3%), and on larger contracts, this might amount to a sizable sum.
What is a typical factoring fee?
The average cost of factoring varies between 1% and 5%. A significant aspect in determining factoring rates is the volume of invoices that needs to be factored.
