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Home > Cash Flow Management Best Practice > Factoring and Invoice Discounting: Working Capital Management Options

Cash Flow Management Best Practice

Factoring and Invoice Discounting: Working Capital Management Options

by Irena Jindrichovska

Executive Summary

  • Factoring is often understood by businesses to be invoice discounting. However, it is, in fact, the sale of receivables, whereas invoice discounting is borrowing, where receivables are used as collateral.

  • In recent years, factoring has experienced substantial growth, as it has become an important source of financing for both small and medium-size enterprises (SMEs), as well as for export corporations.

  • Both factoring and invoice discounting are methods that help to speed up the collection of receivables, and thus increase asset turnover and profit generation for corporate shareholders.

  • Both factoring and invoice discounting directly affect the performance of corporations as they impact on working capital, and affect the performance of asset turnover and profit generation.

Factoring

Factoring is provided by financial institutions, for example banks and individual factoring brokers. It is a form of asset-based financing, where the factor provides funding based upon the values of a borrower’s accounts receivable, i.e. corporate debtors. The receivables are purchased by the factor rather than used as collateral for a loan. This means that the ownership of receivables shifts from the seller to the factor. Factoring generally includes more than just financing, and it also includes funding and collection (Booth and Cleary, 2007).

Factoring and invoice discounting in the UK is being used by more than 47,000 companies, with a total volume of €170,000 billion in 2003 (Bakker et al., 2004). It is a popular method of working capital management in many countries, and is especially helpful for start-up companies, as well as small and medium-size corporations, to use their working capital more effectively.

Factoring offers some advantages for the factor over lending, and is likely to become more important in transitional and developing countries. The funding provided to the customer is explicitly linked to the value of their underlying assets (working capital), and not to the borrower’s overall creditworthiness. This portfolio of assets (receivables) is being continuously managed, to ensure that the value of the underlying assets always exceeds the amount of credit.

Features and Parameters of Factoring

Factoring can be done on both a recourse and non-recourse basis. In developed financial markets, factoring is done on a non-recourse basis. The factor does not have a claim against its client (the borrower) if the accounts default. In less-mature financial markets, recourse factoring is used, where the factor has a claim against its borrower for deficiencies of purchased receivables. Therefore, the factor would suffer a loss only if the underlying accounts are not paid, while, at the same time, the borrower cannot cover the deficiency. In recourse factoring, all the debts are at the client’s risk in the event of customer failure. The factoring company is taking little risk. In these cases, one might expect that the factor would not be restrictive as to whom the company is selling the product. However, factors impose credit risks and concentration limits that restrict the funding of their clients. This is also an important aspect of risk management on the part of factors.

Factoring can be also be done on a notification and a non-notification basis. Under notification, the debtors are notified that their payables have been sold to a factor. In general, factoring with recourse does not include notification, but factoring without recourse does. (In many countries, factoring has a negative connotation, so some clients prefer factors that do not notify their debtors.)

In reality, a factor provides three linked services: financing, assuming credit risk, and a collection service. The collection service involves collecting current accounts, and the collecting of non-performing accounts. This helps to minimize losses associated with bad debts to the client.

Factors typically pay less than 100% of the face value of receivables, even though they take ownership of the whole amount. The difference between those amounts creates a reserve held by the factor. This reserve will be used to cover deficiencies in the payment of invoices.

In world trade, factorable products often flow from developing countries to developed countries. This creates opportunities for export factoring. Export factoring is the principal type of factoring in most developing and transitional countries because it is, in many cases, easier and safer to factor export receivables than domestic receivables. Obviously, in these cases, all parties to the transaction will face an exchange-rate risk, which needs to be mitigated with the help of financial institutions.

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Further reading

Books:

  • Bakker, M., L. Klapper, and G. Udell. Financing Small and Medium-size Enterprises with Factoring: Global Growth and Its Potential in Eastern Europe. Washington, DC: World Bank, 2004.
  • Booth, L., and W. S. Cleary. Introduction to Corporate Finance. Toronto, ON: Wiley, 2007.
  • Klapper, L. The Role of Factoring for Financing Small and Medium Enterprises. Washington, DC: World Bank, 2005.
  • Meckin, D. Naked Finance: Business and Finance Pure and Simple. London: Nicolas Brealey Publishing, 2007.

Article:

  • Soufani, K. “Factoring as a financing option: Evidence from the UK.” Working paper, Concordia University, 2003.

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