Factoring (finance)

Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm’s credit worthiness. Secondly, factoring is not a loan – it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.
It is different from the forfaiting in the sense that forfaiting is a transaction based operation while factoring is a firm-based operation - meaning, in factoring, a firm sells all its receivables while in forfaiting, the firm sells one of its transactions.
Factoring is a word often misused synonymously with invoice discounting factoring is the sale of receivables whereas invoice discounting is borrowing where the receivable is used as collateral.
The three parties directly involved are: the one who sells the receivable, the debtor, and the factor. The receivable is essentially a financial 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), 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 and risks associated with the receivables. Accordingly, the factor obtains the right to receive the payments made by the debtor for the invoice amount and must bear the loss if the debtor does not pay the invoice amount. Usually, the account debtor is notified of the sale of the receivable, and the factor bills the debtor and makes all collections. Critical to the factoring transaction, the seller should never collect the payments made by the account debtor, otherwise the seller could potentially risk further advances from the factor. There are three principal parts to the factoring transaction; a.) the advance, a percentage of the invoice face value that is paid to the seller upon submission, b.) the reserve, the remainder of the total invoice amount held until the payment by the account debtor is made and c.) the fee, the cost associated with the transaction which is deducted from the reserve prior to it being paid back the seller. Sometimes the factor charges the seller a service charge, as well as interest based on how long the factor must wait to receive payments from the debtor. The factor also estimates the amount that may not be collected due to non-payment, and makes accommodation for this when determining the amount that will be given to the seller. The factor's overall profit is the difference between the price it paid for the invoice and the money received from the debtor, less the amount lost due to non-payment.
American Accounting considers the receivables sold when the buyer has "no recourse", or when the financial transaction is substantially a transfer of all of the rights associated with the receivables and the seller's monetary Liability under any "recourse" provision is well established at the time of the sale. Otherwise, the financial transaction is treated as a loan, with the receivables used as collateral.
Contents

1 Reason
2 Differences from bank loans
3 Invoice sellers
4 Factors
5 Invoice payers (debtors)
6 Risks
7 History

Reason

Factoring is a method used by a firm to obtain Cash 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. The use of Factoring to obtain the Cash needed to accommodate the 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. 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." Accordingly, Factoring occurs when the rate of return on the proceeds invested in production exceed the costs associated with Factoring the Receivables. Therefore, the trade off between the return the firm earns on investment in production and the cost of utilizing a Factor is crucial in determining both the extent Factoring is used and the quantity of Cash the firm holds on hand.
Many businesses have Cash Flow that varies. A business might have a relatively large Cash Flow in one period, and might have a relatively small Cash Flow in another period. Because of this, firms find it necessary to both maintain a Cash Balance on hand, and to use such methods as Factoring, in order to enable them to cover their Short Term cash needs in those periods in which these needs exceed the Cash Flow. Each business must then decide how much it wants to depend on Factoring to cover short falls in Cash, and how large a Cash Balance it wants to maintain in order to ensure it has enough Cash on hand during periods of low Cash Flow.
Generally, the variability in the cash flow will determine the size of the Cash Balance a business will tend to hold as well as the extent it may have to depend on such financial mechanisms as Factoring. Cash flow variability is directly related to 2 factors:
The extent Cash Flow can change,
The length of time Cash Flow can remain at a below average level.
If cash flow can decrease drastically, the business will find it needs large amounts of cash from either existing Cash Balances or from a Factor to cover its obligations during this period of time. Likewise, the longer a relatively low cash flow can last, the more cash is needed from another source (Cash Balances or a Factor) to cover its obligations during this time. As indicated, the business must balance the opportunity cost of losing a return on the Cash that it could otherwise invest, against the costs associated with the use of Factoring.
The Cash Balance a business holds is essentially a Demand for Transactions Money. As stated, the size of the Cash Balance the firm decides to hold is directly related to its unwillingness to pay the costs necessary to use a Factor to finance its short term cash needs. The problem faced by the business in deciding the size of the Cash Balance it wants to maintain on hand is similar to the decision it faces when it decides how much physical inventory it should maintain. In this situation, the business must balance the cost of obtaining cash proceeds from a Factor against the opportunity cost of the losing the Rate of Return it earns on investment within its business. The solution to the problem is:

where CB is the Cash Balance, nCF is the average Negative Cash Flow in a given period, i is the [Discount Rate] that cover the Factoring Costs, and r is the rate of return on the firm’s assets.

Differences from bank loans

Factors make funds available, even when banks would not do so, because factors focus first on the credit worthiness of the debtor, the party who is obligated to pay the invoices for goods or services delivered by the seller. In contrast, the fundamental emphasis in a bank lending relationship is on the creditworthiness of the borrower, not that of its customers. While bank lending is cheaper than factoring, the key terms and conditions under which the small firm must operate differ significantly.
From a combined cost and availability of funds and services perspective, factoring creates wealth for some but not all small businesses. For small businesses, their choice is slowing their growth or the use of external funds beyond the banks. In choosing to use external funds beyond the banks the rapidly growing firm’s choice is between seeking venture capital (i.e., equity) or the lower cost of selling invoices to finance their growth. The latter is also easier to access and can be obtained in a matter of a week or two, whereas securing funds from venture capitalists can typically take up to six months. Factoring is also used as bridge financing while the firm pursues venture capital and in conjunction with venture capital to provide a lower average cost of funds than equity financing alone. Firms can also combine the three types of financing, angel/venture, factoring and bank line of credit to further reduce their total cost of funds whilst at the same time improving cash flow.
As with any technique, factoring solves some problems but not all. Businesses with a small spread between the revenue from a sale and the cost of a sale, should limit their use of factoring to sales above their breakeven sales level where the revenue less the direct cost of the sale plus the cost of factoring is positive.
While factoring is an attractive alternative to raising equity for small innovative fast-growing firms, the same financial technique can be used to turn around a fundamentally good business whose management has encountered a perfect storm or made significant business mistakes which have made it impossible for the firm to work within the constraints of their bank covenants. The value of using factoring for this purpose is that it provides management time to implement the changes required to turn the business around. The firm is paying to have the option of a future the owners control. The association of factoring with troubled situations accounts for the half truth of it being labeled 'last resort' financing. However, use of the technique when there is only a modest spread between the revenue from a sale and its cost is not advisable for turnarounds. Nor are turnarounds usually able to recreate wealth for the owners in this situation.
Large firms use the technique without any negative connotations to show cash on their balance sheet rather than an account receivable entry, money owed from their customers, particularly when these show payments being due for extended periods of time beyond the North American norm of 60 days or less.

Invoice sellers

The invoice seller presents recently generated invoices to the factor in exchange for an amount that is less than the value of the invoice(s) by an agreed upon discount and a reserve. A reserve is a provision to cover short payments, payment of less than the full amount of the invoice by the debtor, or a payment received later than expected. The result is an initial payment followed by a second one equal to the amount of the reserve if the invoice is paid in full and on time or a credit to the account of the seller with the factor. In an ongoing relationship the invoice seller will get their funds one or two days after the factor receives the invoices. Astute invoice sellers can use a combination of techniques to cover the range of 1% to 5% plus cost of factoring for invoices paid within 50 to 60 days or more. In many industries, customers expect to pay a few percentage points higher to get flexible sales terms. In effect the customer is willing to pay the supplier to be their bank and reduce the equity the customer needs to run their business. To counter this it is a widespread practice to offer a prompt payment discount on the invoice. This is commonly set out on an invoice as an offer of a 2% discount for payment in ten days. {Few firms can be relied upon to systematically take the discount, particularly for low value invoices - under $100,000 - so cash inflow estimates are highly variable and thus not a reliable basis upon which to make commitments.} Invoice sellers can also seek a cash discount from a supplier of 2 % up to 10% (depending on the industry standard) in return for prompt payment. Large firms also use the technique of factoring at the end of reporting periods to ‘dress’ their balance sheet by showing cash instead of accounts receivable. There are a number of varieties of factoring arrangements offered to invoice sellers depending upon their specific requirements. The basic ones are described under the heading Factors below.

Factors

When initially contacted by a prospective invoice seller, the factor first establishes whether or not a basic condition exists, does the potential debtor(s) have a history of paying their bills on time? That is, are they creditworthy? (A factor may actually obtain insurance against the debtor’s becoming bankrupt and thus the invoice not being paid.) The factor is willing to consider purchasing invoices from all the invoice seller’s creditworthy debtors. The classic arrangement which suits most small firms, particularly new ones, is full service factoring where the debtor is notified to pay the factor (notification) who also takes responsibility for collection of payments from the debtor and the risk of the debtor not paying in the event the debtor becomes insolvent, non recourse factoring. This traditional method of factoring puts the risk of non-payment fully on the factor. If the debtor cannot pay the invoice due to insolvency, it is the factor's problem to deal with and the factor cannot seek payment from the seller. The factor will only purchase solid credit worthy invoices and often turns away average credit quality customers. The cost is typically higher with this factoring process because the factor assumes a greater risk and provides credit checking and payment collection services as part of the overall package. For firms with formal management structures such as a Board of Directors (with outside members), and a Controller (with a professional designation), debtors may not be notified (i.e., non-notification factoring). The invoice seller may not retain the credit control function. If they do then it is likely that the factor will insist on recourse against the seller if the invoice is not paid after an agreed upon elapse of time, typically 60 or 90 days. In the event of non-payment by the customer, the seller must buy back the invoice with another credit worthy invoice. Recourse factoring is typically the lowest cost for the seller because they retain the bad debt risk, which makes the arrangement less risky for the factor.
Despite the fact that most large organizations have in place processes to deal with suppliers who use third party financing arrangements incorporating direct contact with them, many entrepreneurs remain very concerned about notification of their clients. It is a part of the invoice selling process that benefits from salesmanship on the part of the factor and their client in its conduct. Even so, in some industries there is a perception that a business that factors its debts is in financial distress.

Invoice payers (debtors)

Large firms and organizations such as governments usually have specialized processes to deal with one aspect of factoring, redirection of payment to the factor following receipt of notification from the third party (i.e., the factor) to whom they will make the payment. Many but not all in such organizations are knowledgeable about the use of factoring by small firms and clearly distinguish between its use by small rapidly growing firms and turnarounds.
Distinguishing between assignment of the responsibility to perform the work and the assignment of funds to the factor is central to the customer/debtor’s processes. Firms have purchased from a supplier for a reason and thus insist on that firm fulfilling the work commitment. Once the work has been performed however, it is a matter of indifference who is paid. For example, General Electric has clear processes to be followed which distinguish between their work and payment sensitivities. Contracts direct with US Government require an Assignment of Claims which is an amendment to the contract allowing for payments to third parties (factors).

Risks

The most important risks of a factor are:
Counter party credit risk related to clients and risk covered debtors. Risk covered debtors can be reinsured, 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, not assigned credit notes, etc. A fraud insurance policy and subjecting the client to audit could limit the risks.
Legal, compliance and tax risks: large number of applicable laws and regulations in different countries.
Operational risks, such as contractual disputes.
Uniform Commercial Code (UCC-1) securing rights to assets.
IRS liens associated with payroll taxes etc.
ICT risks: complicated, integrated factoring system, extensive data exchange with client.