About receivables finance
Factoring is a form of short-term commercial finance based on the selling of trade debts at a discount from one party to another, or as the Concise Oxford English Dictionary puts it:
‘To buy at a discount the debts owed to another, in order to profit by collecting them.’
DEFINITION OF FACTORING
There have been various attempts over the years to define factoring more precisely. Some definitions are now dismissed as no longer appropriate, others are still being debated or interpreted in different ways.
The problem with trying to define factoring precisely is that the term is generic and is used to describe a number of related financial services. These services are being added to, or altered according to market forces and therefore any definition is continually in a state of flux. As such, a precise definition of factoring is not practical. For the purposes of this report, however, factoring is considered to be the following:
A continuous arrangement between a factoring concern and the seller of business goods or services on credit, whereby the factor purchases accounts receivable for immediate cash, and may, depending on the exact nature of the arrangement:
- Maintain the sales ledger and perform other administrative tasks relating to accounts receivable functions;
- Collect the accounts receivable;
- Provide bad debt protection by absorbing losses, which may arise as a result of the customer’s inability to pay.
THE MAIN SERVICES
The main services are described below using ‘traditional’ industry terminology, which the majority of factors still use and in any event, will all recognise. It should be noted that there may be variations in the way different factors provide similarly named services.
Services provided by the factors are many and varied. The basic ingredients for these services are as follows:
- With or without bad debt protection (non-recourse or recourse);
- With or without disclosure to customers (non-confidential or confidential);
- Where collection of debts is undertaken by the factor or by the client on behalf of the factor;
- Agreements, which provide for the assignment of all debts as they arise (whole turnover) or which provide for each debt to be offered to the factor (facultative).
The situation is further complicated by inconsistency in the labelling used by factors for their various types of services.
In recognition of the difficulty that many businesses encounter with much of the terminology surrounding receivables finance, some factors are now avoiding the use of the terms ‘factoring’ and ‘invoice discounting’. For instance, HSBC and Royal Bank of Scotland Commercial Services now refer to their services as ‘Invoice Finance’, while Barclays use the term ‘Sales Finance’. However, apart from the different terminology, the services are essentially unchanged.
THE FULL SERVICE
Probably the most common form of factoring (in terms of client numbers) is the ‘full service’ arrangement whereby the factor, as part of a continuous cycle, agrees to purchase the invoices of the client as they arise in the normal course of trading. In addition to purchasing the debts, the factor will also administer and control the client’s sales ledger and collect due debts from the client’s customers. The factor will also provide regular and detailed documentation detailing receipt of invoices from the client, advances, payments by the customer, and other reports relating to sales ledger activity.
There are basically two types of full-service arrangement:
Recourse – whereby the factor does not provide protection against bad debts. In the event of a bad debt (or possibly before, depending on the age of the debt) the factor will recover from the client’s account moneys advanced against the debt.
Non-recourse – whereby the factor absorbs losses incurred by a customer’s inability to pay. Also known as ‘bad debt protection’. The factor will usually set credit limits for customers and sometimes expect the client to absorb some of any loss.
The smaller independent factors, whilst not always offering non-recourse arrangements, will often arrange bad debt protection through a trade credit insurance company such as Coface or Atradius (formerly Gerling).
This is sometimes known as ‘bulk factoring’. Here, the arrangement still requires that the debtors be informed that all payments go to the factor but the client takes responsibility for the collection of debts, effectively acting as agent for the factor.
The arrangement is usually with full recourse and is purely for financing the trade credit requirements of the client’s debtors. The service is similar to invoice discounting and is appropriate where the client’s sales ledger operation is well managed and there is a large number of, usually small, accounts.
Often the client would either not be well established and/or too small for an invoice discounting arrangement. Agency factoring is also an option when full factoring would be prohibitively expensive because of a large number of low value debts.
Invoice discounting is provided for clients requiring finance but not sales-ledger administration or credit protection. The service is an increasingly popular choice among larger businesses (typically of turnover GBP2 million+). The client is not required to notify his debtors to pay direct to the factor (hence it was sometimes known as ‘confidential factoring’, although confidential services are now available through full factoring) and the debts are normally subject to full recourse. This is a purely financial service whereby the client maintains the sales ledger and collects from debtors on behalf of the factor to whom the debts have been assigned. The client, on collection of debts, pays the proceeds into the factor’s bank account. This form of factoring is more often provided by larger factoring companies because of the greater sums involved.
Some factors will accept the purchase of debts for goods or services sold to foreign customers. In this situation the factor will usually employ a correspondent in the country of the importer to manage the collection and cover the credit risk.
There are a number of other forms of receivables finance service available, which are sometimes referred to as factoring. Most are slight variations of the main services above, while others are a combination of receivables finance and other forms of asset finance.
Asset-based lending is a form of funding which operates in a similar manner to factoring. However, in addition to funding against trade debts, other assets can be taken into consideration such as stock and property.
Because other assets apart from trade debts are taken into consideration, the amount of funding available is often increased. As such, factors offering this service often advertise 100pc or more funding against debtors.
MERCHANT TRADE FINANCE
Strictly speaking this is not factoring (by traditional definitions), although it is a form of debtor finance. Its operation is similar to that of factoring.
In merchant trade finance, the client sells his product to the merchant trader who then sells it to the client’s customer. The client at the same time delivers the product to the customer, effectively acting as agent for the merchant trader. The merchant trader pays the client up to 80pc of the invoice value and the balance, minus charges, on payment by the customer.
Although generally more expensive than factoring, merchant trading does not usually require that all of the client’s invoices are sold. Another advantage is that it does not affect any existing charge over book debts, which, in the case of factoring, would normally have to be waived in favour of the factor.
One of the more recent developments is for some larger factors to position themselves as one-stop finance shops for SMEs, providing not only factoring, but other asset-based financing solutions such as leasing and other services, including credit insurance and even back-office functions like payroll facilities.