Receivables and payables management - Factoring and invoice ...

Learning Outcomes

After reading this article, you will be able to explain the differences between factoring, invoice discounting, and internal credit administration for managing receivables and payables. You will assess the advantages and disadvantages of external finance (factoring/invoice discounting) versus internal administration, and identify the key factors that influence the choice of each method for effective working capital management.

ACCA Foundations in Financial Management (FFM) Syllabus

For ACCA Foundations in Financial Management (FFM), you are required to understand the techniques available for managing receivables and payables. This article will help you revise:

• The main methods for managing trade receivables and payables, including factoring, invoice discounting, and internal processes
• The features, benefits, and limitations of factoring and invoice discounting services
• Key considerations in choosing between external finance and internal credit control
• The effect of different receivables/payables management approaches on cash flow, profit, risk, and administrative workload

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following options provides both finance and full sales ledger administration to a business?
   1. Invoice discounting
   2. Full factoring
   3. Internal administration
   4. Hire purchase
2. What is the main risk if a company relies exclusively on internal administration of receivables without adequate procedures?
   1. Overstated cash balances
   2. Increased irrecoverable debts
   3. Immediate payment from customers
   4. Reduced cost of finance

3. True or false? Invoice discounting arrangements are always disclosed to a business's customers.

4. What are two key differences between factoring and invoice discounting?

Introduction

Efficient management of receivables and payables is essential for healthy cash flow and liquidity. Businesses can handle credit control in-house or use external services such as factoring or invoice discounting. Each method has different impacts on risk, costs, cash flow, and workload. Understanding the features, benefits, and limitations of these options is important for making informed choices to support financial performance and control.

Key Term: factoring
An arrangement where a business sells its trade receivables to a specialist finance company (the factor) in exchange for immediate cash, with the factor often also taking over credit control and collections.

Key Term: invoice discounting
A form of finance where a business borrows against the value of its outstanding sales invoices but retains responsibility for collecting payments from customers; customers are usually unaware of the arrangement.

Key Term: internal credit administration
The in-house processes a business uses to set credit terms, assess customer reliability, chase debts, and manage the sales and purchase ledgers without external involvement.

APPROACHES TO RECEIVABLES AND PAYABLES MANAGEMENT

Businesses have three main alternatives for managing receivables and payables:

• Internal credit administration (in-house)
• Factoring (full or selected)
• Invoice discounting

Each choice affects administration, risk, cash flow, costs, and customer relations.

Internal Credit Administration

Most businesses set credit policies and manage their sales and purchase ledgers internally. This involves:

• Assessing customer creditworthiness before granting credit
• Setting credit limits and payment terms
• Issuing invoices and statements
• Chasing overdue accounts
• Reconciling supplier balances and negotiating payment terms

The main advantages include lower direct costs and greater control over customer relationships. However, it requires strong internal controls, dedicated staff, and a reliable IT system. Weaknesses in procedures may lead to bad debts or poor cash flow.

Revision Tip For the exam, be ready to compare internal administration with external options in terms of control, cost, and risk.

Factoring

Factoring is offered by specialist finance companies (factors) and is used mainly by businesses with significant credit sales. The key services a factor may provide are:

• Finance: Advance payment, typically 70–90% of invoice value, with the balance paid after customer settles (less fees)
• Sales ledger administration: Management of all invoicing, collections, and chasing slow payers
• Bad debt protection: In a “non-recourse” arrangement, the factor accepts responsibility if a customer does not pay

There are two main types:

• Recourse factoring: The business bears the risk if the customer defaults
• Non-recourse factoring: The factor accepts the credit risk

Customers are notified that payments must be made directly to the factor.

Advantages of Factoring

• Immediate improvement of cash flow
• Reduced credit control workload—factor handles collections
• Reduced risk of irrecoverable debt (in non-recourse arrangements)

Disadvantages of Factoring

• Can be expensive—factors charge service and finance fees
• May affect customer relationships (since a third party chases debts)
• Customers may see use of factoring as a sign of financial weakness
• Not all sales are eligible—some debts may be excluded

Invoice Discounting

Invoice discounting is similar to factoring in that it provides early access to funds tied up in receivables. However, key features differ:

• The business retains control over its sales ledger and collection process
• The arrangement is usually confidential—customers pay the business as normal
• The finance company advances a percentage of invoice value (typically 70–85%)
• The discounted invoices serve as security for the advance

This method is more suitable for well-established companies with strong internal credit controls.

Advantages of Invoice Discounting

• Improved cash flow without customers being aware of external involvement
• Retention of client relationships and in-house credit control
• Generally lower cost than full factoring

Disadvantages of Invoice Discounting

• The business remains responsible for chasing debts and risk of bad debts
• Not suitable for businesses with poor record-keeping or weak credit control
• Usually available only to larger, well-run companies

SELECTING THE RIGHT APPROACH: FACTORS TO CONSIDER

When deciding on a receivables/payables management method, businesses should consider:

• Cost: Direct fees for factoring/invoice discounting vs cost of in-house staff/systems
• Control: Internal admin keeps customer contact in-house; factoring outsources it
• Cash flow needs: Faster access to cash via factoring/invoice discounting may be critical
• Risk appetite: Non-recourse factoring reduces bad debt risk
• Customer perception: Use of factoring may signal financial distress to some customers
• Business size and resources: Small firms may lack the staff for robust internal control; large firms may negotiate better terms with finance providers

Worked Example 1.1

A small wholesaler has trade receivables of $300,000 and faces increasing late payments. Internal admin costs $10,000 per year. A factor offers to advance 80% of receivables instantly, for a 2% service fee and 6% annual finance cost.

Should the wholesaler use factoring or continue in-house administration?

Answer:
The business should compare the yearly cost of factoring (service fee: $6,000 plus finance costs, plus loss of control) with the current admin cost and assess whether immediate cash inflow and reduced bad debt risk justify the extra cost. If cash flow is tight or debt collection is ineffective, factoring may be the better choice.

Worked Example 1.2

A manufacturer with tight profit margins considers invoice discounting instead of factoring to improve cash flow but wants to maintain direct client relationships. The company has a robust credit control system.

Is invoice discounting appropriate in this scenario?

Answer:
Yes. Invoice discounting provides the finance the business needs, keeps collections confidential and under internal control, and is generally cheaper than full factoring. It is suitable because the business has strong internal credit management in place.

Exam Warning

Be aware: Not all factoring includes bad debt protection. Many factors operate on a “recourse” basis, leaving you exposed if customers default. Always specify which type is being considered when answering exam questions.

Summary

Factoring and invoice discounting are external finance solutions that give quick access to cash tied up in receivables. Factoring often includes full administration and can limit bad debt risk, but at higher cost and less control. Invoice discounting is less intrusive and confidential but places responsibility for collections and risk with the business. Internal administration is cheapest for those with strong systems and low risk, but may not suit companies with high growth or weak controls.

Key Point Checklist

This article has covered the following key knowledge points:

• The role of internal credit administration, factoring, and invoice discounting in managing receivables/payables
• The main features, benefits, and drawbacks of each approach
• The differences between recourse and non-recourse factoring
• How each method impacts cash flow, control, risk, and workload
• Factors to consider when choosing between internal or external management

Key Terms and Concepts

• factoring
• invoice discounting
• internal credit administration