Payroll Factoring: An Introduction

Payroll factoring is an increasingly tempting choice for many new and growing SMEs. In this guide we’ll explain the fundamentals of payroll factoring and help to answer your questions on whether payroll factoring is the right choice for your company.

What You Need to Know About Payroll Factoring

Factoring is a long-established practice in which companies manage cash flow by selling its accounts receivable, or invoices and payroll factoring is no different. It is an alternative to bank loans, and can be cheaper and less risky. It can be an efficient way of borrowing for fast-growing firms that have a high-quality client base but payment terms that are longer than short-term claims on the company’s cash.

Payroll Factoring

How Does Payroll Factoring Work?

There are two ways of arranging payroll factoring: confidential invoice discounting and invoice factoring. In the first case the client continues to collect the cash, in the second this task is handled by the financing company, typically a large bank. The term ‘payroll factoring’ arises in companies, typically staffing agency firms, where the payroll constitutes almost the whole of the company’s turnover.

On cash flow there are significant advantages to invoice financing, especially during the growth phase. A search and selection agency, especially one that is quite young and still growing, may have limited cash reserves. If it has a base of temporary staff – for example it has placed 100 contractors – it is billing thousands of pounds a week. For each one it will be paid 30 days to five weeks later, but will have to start paying them from week 2.

Carrying £100,000 a week or so gross costs; for five weeks means half a million pounds cash flow requirement. The company will have billed it, so is due to receive the funds with a margin. If the agency has good quality clients like local governments and public limited companies and other established firms, it will be able to arrange payroll factoring with a financial institution, typically a bank. The bank will carry out credit checks, and arrange the finance, subject to an interest and a facility charge.

Larger, mature staffing agencies typically do not have a need to arrange invoice financing, as they have sufficient reserves to be able to meet their requirements. The situation where such arrangements are most likely to make business sense are where:

  • The company is young, but growing quickly,
  • Their cash requirements are on a shorter time-scale than typical payment terms and the gap between the two is significant,
  • There are significant business advantages, such as gaining market share, in strong growth rates, that outweigh the costs of invoice financing,

The company has a low-risk client base, including major public sector organizations and established firms.

Typically, a company will have a turnover of more than £200,000 before being eligible for invoice financing, but a financial institution may consider a start-up with lower turnover. There should be reasonable diversity of clients, and no one debtor should account for more than 25-40% of the business, according to advice by the Institute of Directors. Too many small invoices may make factoring uneconomical.

Payroll Factoring / Invoice Discounting

Invoice discounting is common: the agency sector, where the practice may be referred to as ‘payroll factoring’, is a significant but minority part of the market. Any sales ledger is an asset that a company can use to obtain finance.

From an agency’s perspective, there is no real risk with payroll factoring, more than the risk that they will be running as a business anyway: if there are concerns about the quality of a significant number of the creditors, this would affect the business in any case. A major advantage over a bank business loan is that this can be called in, often at short notice, and sometimes owing to issues that are more to do with the bank or the general economy than with the client.

Umbrella companies

Specialist payroll companies, known as ‘umbrella companies’, are often confused for staffing agencies, but they are not the same. Umbrella companies are specialist outsourced payroll providers for individual freelancers and contractors. They handle the tax compliance and other aspects of Pay-As-You-Earn on behalf of the individuals.

Umbrella companies have no need for payroll factoring: they get the instructions to pay along with the cash, so there is not the same gap in financing terms. Their use has grown considerably in recent years owing both to an increase in the self-employment market and changes in tax regimes. There has been tightening of rules by tax revenue authorities to ensure that individual contractors pay their full amount of income tax and social security contributions. Construction and IT, in particular, feature significant numbers of individual contractors who use umbrella companies to run their payroll. In the UK, for example, the IR35 rules are designed to ensure that contractors’ income is taxed at the same or similar rate to company employees, and in particular to clamp down on the use of contractors as ‘disguised employees’ of a contracting organization. If you’re considering payroll factoring, take a look at some of the resources (external) below and read some of our own guides to payroll outsourcing on Payroll Report.

Payroll Factoring: Useful Resources

Institute of Directors, Directors Briefing – Factoring and Invoice Discounting

Forum of Private Business: advice on invoice financing

HM Revenue & Customs advice on IR35:

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