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More detail - How does it work?

Page 2 of 2: How does it work?

How does it work?

In most markets, Factoring is effected through the selling of invoices using a process known as assignment. This legal process transfers the ownership of the sales invoices from the Seller to the Factor. 

In this way, Factoring is different from a traditional loan where monies are passed on the basis that they may be secured against an asset which remains the property of the borrower. Here the invoices become the property of the Factor, who transfers money to the seller. The Factor is then economically free to dispose of (for example re-sell) the receivables assigned to him. 

It is often the case that the buyer must be advised of the assignment for the process to be effective. So the invoice (physical or electronic) will normally carry a notice of assignment to advise the buyer that it has been sold to the Factor and payment must be made to it, not to the seller. The Factor may from time to time also send letters and statements which remind of the buyer of this transfer of ownership.

In most factoring arrangements, once the invoices have been assigned (and in some case checked or verified to confirm their validity) the Factor will normally immediately make available a proportion of the invoice value to the Seller. This proportion varies depending on the agreement and is typically between 80 and 90% of the face value of the invoices accepted for funding. 

If invoices are assigned which fall outside pre-agreed conditions or limits, (for example if debtor limits are exceeded or the concentration of debt in a particular buyer goes beyond an agreed percentage) it is possible that they will not be financed immediately but will be subject to further investigation or discussion.

The Factor will want to maximize the level of funding available to the Seller, and the seller will want to ensure there are no restrictions on their cash flow from the facility. 

Because of these imperatives, both parties will work together in advance of assignment to ensure that any potential barriers to immediate funding are removed.

Any new business for the Seller can be referred to the Factor who can undertake a credit reference check on a buyer to assess its financial strength and to set an appropriate funding limit. If credit protection is included as part of the factoring agreement, a cover limit can also be set.

As a process for Risk Control, the Factor will regularly contact buyers to confirm that the debt represented by the invoice is good and due for payment after the agreed period of credit. 

The Factor may use a combination of methods to contact the buyers including telephone, e-mail, letters and ledger statements. This collection process and its timing will usually be agreed in detail with the seller.

When the buyer pays the Factor, the payment will be allocated to the seller’s account and the appropriate sales ledger management accounting entries made. The Factor will make available to the seller the balance of the invoice value (remember that the seller has already received 80-90% of its value) less its service fees and the discount charge.

It’s perhaps easy to see how this works for a single invoice but of course in the real world there will be a constant stream of new invoices, payments to the seller, receipts from the buyers and the reality is more complex. However, the principle always remains the same.

As new invoices are assigned and payments are made to the seller, the total balance of the advances account increases. As payments are received in from buyers, the total balance reduces. On a day to day basis, the effect is to create a facility that rises and falls according to the total value of invoices outstanding, the payments made and received. 

In this sense, the advances account is a little analogous to an overdraft; as payments are made out, the balance increases, as payments are received, the balance reduces. But the clear difference from the bank overdraft is that these are purchase payments for the invoices and not a loan against them.