Factoring is a form of financing uses invoiced debtors as a security against which to raise money and outsources the management and collection of this debt.
A business using factoring issues invoices that require the debtor to directly pay the factor. The factor pays part of the invoiced amount immediately. The effect of using factoring is that most of the revenue from each sale is received immediately on invoicing.
When the invoice is paid the factor pays the rest of the value of the invoice less interest and fees.
The factor also takes over management of collecting the invoices. This means that the factor will collect money from customers, send statements to customers, do at least some following up of invoices that are not settled on time. In the case of non-recourse factoring the factor is wholly responsible for collecting debts.
Recourse vs non-recourse factoring
Recourse factoring means that the risk of bad debt remains with the client. The factor must be reimbursed if the invoice remains unpaid. Money raised through recourse factoring is therefore borrowing secured against debtors.
Non-recourse factoring means that the risk of unpaid invoices is taken with the factor. The factor will, obviously, charge more to cover this risk.
Advantages and disadvantages of factoring
- The amount of money raised varies with revenues, making it a good way to fund working capital requirements.
- Non-recourse factoring reduces working capital requirements, as it allows immediate realisation of debtors, shortening the cash cycle.
- It has the usual advantages and disadvantages of outsourcing: reducing non-core workload in exchange, at a cost and causing some loss of control.
- Factoring is a long term contract, and both notice periods and practical constraints (the need to pay off the debt) make ending a factoring agreement messy.
- Factors, being specialists, may be better at getting customers to pay, and at assessing customers' credit worthiness.
- Because customers pay the factor directly, a business's use of factoring is known to them.
- Factoring is usually only available for sales to businesses.
- Non-recourse factoring immediately removes worries about bad debt, and the cost and time required to pursue unpaid debts — but at a cost.
Alternatives to factoring
For those who want factoring without the outsourcing element, this is available (although somewhat less so than factoring) and is called invoice discounting.
Invoices may be used as one asset among many that are used to secure debt. This is often called asset based lending.
The simple alternative of borrowing against other assets should not be forgotten either! Invoice based finance is necessarily complex, and it may be worth avoiding on those grounds alone, as well as when alternatives offer better rates.
Invoice based financing may also be disintermediated though the issue of asset backed securities.