Factoring (finance)


Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable to a third party at a discount. A business will sometimes factor its receivable assets to meet its present and immediate cash needs. Forfaiting is a factoring arrangement used in international trade finance by exporters who wish to sell their receivables to a forfaiter.Please refer to the Wiki article forfaiting for further discussion on cites. Factoring is commonly referred to as accounts receivable factoring, invoice factoring, and sometimes accounts receivable financing. Accounts receivable financing is a term more accurately used to describe a form of asset based lending against accounts receivable. The Commercial Finance Association is the leading trade association of the asset-based lending and factoring industries. In 2019, the Commercial Finance Association rebranded to the Secured Finance Network.
In the United States, factoring is not the same as invoice discounting. Factoring is the sale of receivables, whereas invoice discounting is a borrowing that involves the use of the accounts receivable assets as collateral for the loan. However, in some other markets, such as the UK, invoice discounting is considered to be a form of factoring, involving the "assignment of receivables", that is included in official factoring statistics. It is therefore also 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. Scottish law differs from that of the rest of the UK, in that notification to the account debtor is required for the assignment to take place. The Scottish Law Commission reviewed this position and made proposals to the Scottish Ministers in 2018.

Overview

There are three parties directly involved: the factor who purchases the receivable, the one who sells the receivable, and the debtor who has a financial liability that requires him or her to make a payment to the owner of the invoice. The receivable, usually associated with an invoice for work performed or goods sold, is essentially a financial asset that gives the owner of the receivable the legal right to collect money from the debtor whose financial liability directly corresponds to the receivable asset.J. Downes, J.E. Goodman, "Dictionary of Finance Investment Terms", Baron's Financial Guides, 2003. Taken from a combination of the definitions of a financial asset and accounts receivable The seller sells the receivables at a discount to the third party, the specialized financial organization to obtain cash. This process is sometimes used in manufacturing industries when the immediate need for raw material outstrips their available cash and ability to purchase "on account". synonymous with cash flow requirements to meet current liabilities.
Citation – Manufacturers' uses of Factoring? Both invoice discounting and factoring are used by B2B companies to ensure they have the immediate cash flow necessary to meet their current and immediate obligations. Invoice factoring is not a relevant financing option for retail or B2C companies because they generally do not have business or commercial clients, a necessary condition for factoring.
The sale of the receivable transfers ownership of the receivable to the factor, indicating the factor obtains all of the rights associated with the receivables. Accordingly, the receivable becomes the factor's asset, and the factor obtains the right to receive the payments made by the debtor for the invoice amount, and is free to pledge or exchange the receivable asset without unreasonable constraints or restrictions. 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 collects the accounts sold to the factor, as agent of the factor, also occurs. 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. If the factoring transfers the receivable "without recourse", the factor must bear the loss if the account debtor does not pay the invoice amount. If the factoring transfers the receivable "with recourse", the factor has the right to collect the unpaid invoice amount from the transferor. However, any merchandise returns that may diminish the invoice amount that is collectible from the accounts receivable are typically the responsibility of the seller, and the factor will typically hold back paying the seller for a portion of the receivable being sold in order to cover the merchandise returns associated with the factored receivables until the privilege to return the merchandise expires.
There are four principal parts to the factoring transaction, all of which are recorded separately by an accountant who is responsible for recording the factoring transaction:
  1. the "fee" paid to the factor,
  2. the Interest Expense paid to the factor for the advance of money,
  3. the "bad debt expense" associated with portion of the receivables that the seller expects will remain unpaid and uncollectable,
  4. the "factor's holdback receivable" amount to cover merchandise returns, and any additional "loss" or "gain" the seller must attribute to the sale of the receivables. Sometimes the factor's charges paid by the seller covers a discount fee, additional credit risk the factor must assume, and other services provided.J.G. Siegel, N. Dauber & J.K. Shim, "The Vest Pocket CPA", Wiley, 2005. 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.

    Rationale

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 two factors:
  1. The extent cash flow can change, and
  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 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
  • is the cash balance
  • is the average negative cash flow in a given period
  • is the that cover the factoring costs
  • is the rate of return on the firm's assets. As a general rule, when cash flow tends to be positive on average. However, as mentioned, there are periods of time in which cash flow can be negative.

Today factoring's rationale still includes the financial task of advancing funds to smaller rapidly growing firms who sell to larger more credit-worthy 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 ; daily management reports on collections; and, make the actual collection calls. The outsourced credit function both extends the small firm's 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 back-office functions. More importantly, these services insure entrepreneurs and owners against a major source of a liquidity crises and their equity.