Overview of Short-Term Financing
Factoring Accounts Receivable
Factoring makes it possible for a business to readily convert a substantial portion of its accounts receivable into cash.
Learning Objectives
- Explain the business of factoring and assess the risks of the involved parties
Key Takeaways
Key Points
- Debt factoring is also used as a financial instrument to provide better cash flow control especially if a company currently has a lot of accounts receivables with different credit terms to manage.
- The three parties directly involved in factoring are: the one who sells the receivable, the debtor (the account debtor, or customer of the seller), and the factor.
- There are two principal methods of factoring: recourse and
non-recourse. Under recourse factoring, the client is not protected
against the risk of bad debts. Under non-recourse factoring, the factor
assumes the entire credit risk.
Key Terms
- factoring: A financial transaction whereby a business sells its accounts receivable to a third party (called a factor) at a discount.
Factoring
Factoring is a financial transaction whereby a business sells its accounts receivable to a third party (called a "factor") at a discount. Factoring makes it possible for a business to convert a readily substantial portion of its accounts receivable into cash. This provides the funds needed to pay suppliers and improves cash flow by accelerating the receipt of funds.
Money: Factoring makes it possible for a business to readily convert a substantial portion of its accounts receivable into cash.
Companies factor accounts when the available cash balance held by the
firm is insufficient to meet current obligations and accommodate its
other cash needs, such as new orders or contracts. In other industries,
however, such as textiles or apparel, for example, financially sound
companies factor their accounts simply because this is the historic
method of finance. The use of factoring to obtain the cash needed to
accommodate a firm's immediate cash needs will allow the firm to
maintain a smaller ongoing cash balance. By reducing the size of its
cash balances, more money is made available for investment in the firm's
growth. Debt factoring is also used as a financial instrument to
provide better cash flow control, especially if a company currently has a
lot of accounts receivables with different credit terms to manage. A
company sells its invoices at a discount to their face value when it
calculates that it will be better off using the proceeds to bolster its
own growth than it would be by effectively functioning as its
"customer's bank".
Types of Factoring
There are two principal methods of factoring: recourse and non-recourse. Under recourse factoring, the client is not protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under non-recourse factoring (i.e., the full amount of invoice is paid to the client in the event of the debt becoming bad). Other variations include partial non-recourse, where the factor's assumption of credit risk is limited by time, and partial recourse, where the factor and its client (the seller of the accounts) share credit risk. Factors never assume "quality" risk, and even a non-recourse factor can charge back a purchased account which does not collect for reasons other than credit risk assumed by the factor, (e.g., the account debtor disputes the quality or quantity of the goods or services delivered by the factor's client).
In "advance" factoring, the factor provides financing to the seller of the accounts in the form of a cash "advance," often 70-85% of the purchase price of the accounts, with the balance of the purchase price being paid, net of the factor's discount fee (commission) and other charges, upon collection. In "maturity" factoring, the factor makes no advance on the purchased accounts; rather, the purchase price is paid on or about the average maturity date of the accounts being purchased in the batch.
There are three principal parts to "advance" factoring transaction:
- The advance, a percentage of the invoice's face value that is paid to the seller at the time of sale.
- The reserve, the remainder of the purchase price held until the payment by the account debtor is made.
- The discount fee, the cost associated with the transaction which is deducted from the reserve, along with other expenses, upon collection, before the reserve is disbursed to the factor's client.
Parties Involved in the Factoring Process
The three parties directly involved are the one who sells the receivable, the debtor (the account debtor, or customer of the seller), and the factor. The receivable is essentially an asset associated with the debtor's liability to pay money owed to the seller (usually for work performed or goods sold). The seller then sells one or more of its invoices (the receivables) at a discount to the third party, the specialized financial organization (aka the factor), often, in advance factoring, to obtain cash. The sale of the receivables essentially transfers ownership of the receivables to the factor, indicating the factor obtains all of the rights associated with the receivables. Accordingly, the factor obtains the right to receive the payments made by the debtor for the invoice amount and, in non-recourse factoring, must bear the loss if the account debtor does not pay the invoice amount due solely to his or its financial inability to pay.
Risks in Factoring
The most important risks of a factor are:
- Counter party credit risk: risk covered debtors can be re-insured, which limit the risks of a factor. Trade receivables are a fairly low risk asset due to their short duration.
- External fraud by clients: fake invoicing, mis-directed payments, pre-invoicing, unassigned credit notes, etc. A fraud insurance policy and subjecting the client to audit could limit the risks.
- Legal, compliance, and tax risks: a large number and variety of applicable laws and regulations depending on the country.
- Operational: operational risks such as contractual disputes.