A Reference Guide to Trade Finance TechniquesFactoring
Debt factoring is a technique that allows
a company to raise finance against the
anticipated cash inflows expected from sales.
The finance raising company, usually a small
to medium-sized entity, sells its invoices to
a factor (the entity offering the finance). In
return, the factor will manage the process of
collecting the invoiced receivables from the
company’s customers.
Factoring services are available from both
specialist factoring companies as well as
bank subsidiaries.
How it works
Factoring is a long-term arrangement
between the company seeking to raise
finance and the factor. It is typically used to
effectively speed up cash collection, reducing
the reliance on loan finance to bridge the
gap between the issue of the invoice and the
receipt of cash. Because the management
of the sales ledger is effectively outsourced
to the factoring company, the company also
benefits from reduced internal administration
costs, although this arrangement may give
rise to customer service problems.
When seeking to establish a factoring
arrangement, the company will need to identify
whether it can proceed, especially if alternative
funding arrangements, such as overdrafts
or term loans, are in place. This is because
pledging invoices to the factoring company
will affect the way the company’s liquidity is
viewed by the other finance providers. A term
loan agreement may also explicitly limit or
prohibit a factoring arrangement.
In order to be suitable for a factoring
arrangement, the factoring company will
want to explore the company’s business,
including its cash flow, before entering into an
agreement. In general terms, companies with
high volumes of standard invoices are more
suitable for factoring than companies which
generate small and infrequent numbers of
high-value invoices. This is because the risk
to the factor of the standard invoices can be
more easily assessed. Moreover, where the
company seeking finance is in a specialised
industry, or the items being factored are
perishable, the factor will be nervous of being
left with the assets if invoices remain unpaid.
(This is because in such industries it can be
difficult to find an alternative purchaser for
these assets, especially if the items have to
be recovered first.) In all cases, factoring is
available to companies trading on some form
of credit, with a delay between the issuance
of the invoice and receipt of the cash.
The company should perform its own
credit check of the factoring company. If the
factoring company fails, the agreement is
likely to leave any moneys due to the factor,
not the company raising finance. Failure of the
factor may result in failure of the company.
The factoring company will also set limits
to the agreement. At the very least, the factor
will set a limit with regard to the maximum
advance relative to the value of the invoices.
This will vary, but will typically be in the range
80–90%. In addition, the factor may impose
a limit to the absolute level of credit that it is
prepared to advance to the company.
The agreement should consider
whether the factor will have recourse to
the borrower in the event of non-payment.
Non-recourse factoring represents a
greater risk to the factor, so it is more
expensive than recourse factoring. In
addition, a factor may only offer recourse
factoring, for example if there is a pattern
of non-payment, or the factor considers the
risk of non-payment to be too great.
It is important to negotiate appropriate
terms with the factor before entering into the
agreement. In particular, the process through
which the factor goes to approve invoices for
factoring needs to be appropriate, ensuring
the company benefits from being able to raise
cash on the greatest number of invoices. Any
credit limits imposed by the factoring company
should be assessed for the same reason.
The factor’s method of advancing payment
must also be understood. If recourse factoring
is agreed, the two parties must agree the
point at which a debt is considered unpaid.
Finally, the company must understand the
nature of the agreement period, especially
the notice that both parties must give to end
the agreement (bear in mind the factor may
also decide to end the agreement).