Factoring (finance)

factoringis a financial transaction in which a business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at a discount.

In "advance" factoring, the business owner sells his receivables in the form of invoice to the factor, who makes an advance of 70-85% of the purchase price of the receivable amount. The factor collects the full amount from the customer in due course and pays the balance amount due to the business owner after deducting his commission and other charges. In "maturity" factoring, the factor makes no immediate advance on the purchased accounts;but sees to it that the customer pays the invoiced amount within the stipulated time i.e. on maturity. However, if the customer fails to make payment within the stipulated time e.g. 30 days, the factor makes payment to the client and proceeds to collect the payment from the customer.

Overview

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 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), 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 nonrecourse 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. Usually, the account debtor is notified of the sale of the receivable, and the factor bills the debtor and makes all collections; however, non-notification factoring, where the client (seller) collects the accounts sold to the factor, as agent of the factor, also occurs.

There are three principal parts to "advance" factoring transaction; (a) the advance, a percentage of the invoice face value that is paid to the seller at the time of sale, (b) the reserve, the remainder of the purchase price held until the payment by the account debtor is made and (c) 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. Sometimes the factor charges the seller (the factor's "client") both a discount fee, for the factor's assumption of credit risk and other services provided, as well as interest on the factor's advance, based on how long the advance, often treated as a loan (repaid by set-off against the factor's purchase obligation, when the account is collected), is outstanding. The factor also estimates the amount that may not be collected due to non-payment, and makes accommodation for this in pricing, when determining the purchase price to be paid 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.

Misconceptions

Non-recourse factoring is not a loan. A lender decides to extend credit to a company based on assets, cash flows, and credit history. A factor is more concerned with the credit-worthiness of the company's customers. The factoring transaction is often structured as a purchase of a financial asset, namely the accounts receivable. A non-recourse factor assumes the "credit risk" that an account will not collect due solely to the financial inability of account debtor to pay. However, in the United States, if the factor does not assume credit risk on the purchased accounts, in most cases a court will recharacterize the transaction as a secured loan.

It is different from forfaiting in the sense that forfaiting is a transaction-based operation involving exporters in which the firm sells one of its transactions, while factoring is a Financial Transaction that involves the Sale of any portion of the firm's Receivables.

Factoring is a word often misused synonymously with invoice discounting, known as "Receivables Assignment" in American Accounting ("Generally Accepted Accounting Principles"/"GAAP" propagated by FASB) - factoring is the sale of receivables, whereas invoice discounting is borrowing where the receivable is used as collateral. However, in some other markets, such as the UK, invoice discounting is considered to be a form of factoring involving the assignment of receivables and is included in official factoring statistics. It is therefore not considered to be borrowing in the UK. In the UK the arrangement is usually confidential in that the debtor is not notified of the assignment of the receivable and the seller of the receivable collects the debt on behalf of the factor. In the UK, the main difference between factoring and invoice discounting is confidentiality.

Treatment under GAAP

In the United States, under the Generally Accepted Accounting Principles receivables are considered sold, under Statement of Financial Accounting Standards No. 140, when the buyer has "no recourse,". Moreover, to treat the transaction as a sale under GAAP, the seller's monetary liability under any "recourse" provision must be readily estimated at the time of the sale. Otherwise, the financial transaction is treated as a loan, with the receivables used as collateral.

History

Factoring's origins lie in the financing of trade, particularly international trade. It is said that factoring originated with ancient Mesopotamian culture, with rules of factoring preserved in the Code of Hammurabi.

Factoring as a fact of business life was underway in England prior to 1400, and it came to America with the Pilgrims, around 1620. It appears to be closely related to early merchant banking activities. The latter however evolved by extension to non-trade related financing such as sovereign debt. Like all financial instruments, factoring evolved over centuries. This was driven by changes in the organization of companies; technology, particularly air travel and non-face to face communications technologies starting with the telegraph, followed by the telephone and then computers. These also drove and were driven by modifications of the common law framework in England and the United States.

Governments were latecomers to the facilitation of trade financed by factors. English common law originally held that unless the debtor was notified, the assignment between the seller of invoices and the factor was not valid. The Canadian Federal Government legislation governing the assignment of moneys owed by it still reflects this stance as does provincial government legislation modelled after it. As late as the current century the courts have heard arguments that without notification of the debtor the assignment was not valid. In the United States, by 1949 the majority of state governments had adopted a rule that the debtor did not have to be notified thus opening up the possibility of non-notification factoring arrangements.

Originally the industry took physical possession of the goods, provided cash advances to the producer, financed the credit extended to the buyer and insured the credit strength of the buyer. In England the control over the trade thus obtained resulted in an Act of Parliament in 1696 to mitigate the monopoly power of the factors. With the development of larger firms who built their own sales forces, distribution channels, and knowledge of the financial strength of their customers, the needs for factoring services were reshaped and the industry became more specialized.

By the twentieth century in the United States factoring was still the predominant form of financing working capital for the then high growth rate textile industry. In part this occurred because of the structure of the US banking system with its myriad of small banks and consequent limitations on the amount that could be advanced prudently by any one of them to a firm. In Canada, with its national banks the limitations were far less restrictive and thus factoring did not develop as widely as in the US. Even then factoring also became the dominant form of financing in the Canadian textile industry.

Modern factoring

Today factoring's rationale still includes the financial task of advancing funds to smaller rapidly growing firms who sell to larger more creditworthy organizations. While almost never taking possession of the goods sold, factors offer various combinations of money and supportive services when advancing funds.

Factors often provide their clients four key services: information on the creditworthiness of their prospective customers domestic and international, and, in nonrecourse factoring, acceptance of the credit risk for "approved" accounts; maintain the history of payments by customers (i.e., accounts receivable ledger); daily management reports on collections; and, make the actual collection calls. The outsourced credit function both extends the small firms effective addressable marketplace and insulates it from the survival-threatening destructive impact of a bankruptcy or financial difficulty of a major customer. A second key service is the operation of the accounts receivable function. The services eliminate the need and cost for permanent skilled staff found within large firms. Although today even they are outsourcing such backoffice functions. More importantly, the services insure the entrepreneurs and owners against a major source of a liquidity crises and their equity.

In the latter half of the twentieth century the introduction of computers eased the accounting burdens of factors and then small firms. The same occurred for their ability to obtain information about debtor’s creditworthiness. Introduction of the Internet and the web has accelerated the process while reducing costs. Today credit information and insurance coverage is available any time of the day or night on-line. The web has also made it possible for factors and their clients to collaborate in realtime on collections. Acceptance of signed documents provided by facsimile as being legally binding has eliminated the need for physical delivery of “originals”, thereby reducing time delays for entrepreneurs.

With these advances in technology, invoice factoring providers usually adapt to a specific industry. This often affects additional services offered by the factor in order to best adapt the factoring service to the needs of the business. An example of this includes a recruitment specialist factor offering payroll and back office support with the factoring facility; a wholesale/distribution factor may not offer this additional service. These differences can affect the cost of the facility, the approach the factor takes when collecting credit, the administration services included in the facility and the maximum size of invoices which can be factored.

By the first decade of the twenty first century a basic public policy rationale for factoring remains that the product is well suited to the demands of innovative rapidly growing firms critical to economic growth. A second public policy rationale is allowing fundamentally good business to be spared the costly management time consuming trials and tribulations of bankruptcy protection for suppliers, employees and customers or to provide a source of funds during the process of restructuring the firm so that it can survive and grow.

Rationale for the use of factoring

Factoring is a method used by some firms to obtain cash. Certain 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 financing. 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." 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. It might be relatively large in one period, and relatively small in another period. Because of this, businesses 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:

  1. The extent cash flow can change,
  2. 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.[18] The solution to the problem is:

where

  • is the cash balance
  • is the average negative cash flow in a given period
  • is the [discount rate] that cover the factoring costs
  • is the rate of return on the firm’s assets.

International factoring

Factoring is simply a unique package of services designed to ease the traditional problems of selling on open account. Typical services include investigating the creditworthiness of buyers, assuming credit risk and giving 100% protection against write-offs, collection and management of receivables and provision of finance through immediate cash advances against outstanding receivables.

When export factoring is carried out by members of FCI, the service involves a five or six stage operation.

  • The exporter signs a factoring contract assigning all agreed receivables to an export factor. The factor then becomes responsible for all aspects of the factoring operation.
  • The export factor chooses an FCI correspondent to serve as an import factor in the country where goods are to be shipped. The receivables are then reassigned to the import factor.
  • At the same time, the import factor investigates the credit standing of the buyer of the exporter's goods and establishes lines of credit. This allows the buyer to place an order on open account terms without opening letters of credit.
  • Once the goods have been shipped, the export factor may advance up to 80% of the invoice value to the exporter.
  • Once the sale has taken place, the import factor collects the full invoice value at maturity and is responsible for the swift transmission of funds to the export factor who then pays the exporter the outstanding balance.
  • If after 90 days past due date an approved invoice remains unpaid, the import factor will pay 100% of the invoice value under guarantee.

Not only is each stage designed to ensure risk-free export sales, it lets the exporter offer more attractive terms to overseas customers. Both the exporter and the customer also benefit by spending less time and money on administration and documentation. In all cases, exporters are assured of the best deal in each country. This is because export factors never appoint an import factor solely because the company is a fellow member of FCI. Import factors are invited to compete for business and those with superior services are selected.