Factoring is a form of Receivables Purchase, in which sellers of goods and services sell their receivables (represented by outstanding invoices) at a discount to a finance provider (commonly known as the ‘factor’). A key differentiator of Factoring is that typically the finance provider becomes responsible for managing the debtor portfolio and collecting the payment of the underlying receivables.
- Receivables Finance
- Receivables Services
- Invoice Discounting
- Debtor Finance
A key differentiator of Factoring is that the finance provider advances funds and is then usually responsible for managing the debtor portfolio and collecting the underlying receivables, often also offering protection against the insolvency of the buyer, which may be protected by credit insurance. Indeed, by international convention, known as UNIDROIT (1988), Factoring is traditionally associated with functions beyond pure financing to include collection of receivables, debtor management, and protection against default by debtors.
In Factoring, ownership of the receivable lies with the finance provider and the buyer settles the invoice with the finance provider, not with the seller. Factoring is normally disclosed to the buyer. Factoring is provided with or without recourse depending on aspects such as credit insurance, jurisdiction and market practice. There are multiple variations of Factoring which are separately described, below.
Factoring is usually offered by specialised finance providers operating as factors, explicitly targeting the receivables financing market and serving a wide array of supplier companies including small and medium sized enterprises (SMEs). Factoring has also been extended to large value transactions. Factors may also offer Receivables Discounting services.
The parties to the factoring transaction are the seller and the finance provider. While the buyer is not a party to the factoring agreement, it is both normally aware of the transaction and relied on for payment of the underlying receivables or invoices directly to the finance provider, except for cases where confidential factoring is provided.
Contractual relationships and documentation
A factoring agreement is entered into between the seller (as client), and the finance provider under which the seller provides the finance provider with an assignment of rights (or transfer of title or the equivalent) to the asset(s) being financed, according to the jurisdiction in question. Notice of assignment is usually provided to the buyer; a certified copy of the invoice or the invoice data set is provided to the finance provider. Any additional security is suitably documented.
An assignment of rights (or transfer of title or the equivalent) to the asset(s) being financed, according to the jurisdiction in question. Additional security interests may be taken by the finance provider. Credit insurance is commonly applied.
Risks and risk mitigation
- Default or insolvency of the buyers, including relevant country risk, mitigated by credit and risk assessment, monitoring and potentially credit insurance
- Existence of valid and eligible invoices being factored, mitigated by a regime of sampling and in some cases individual verification
- Concentration risk mitigated by setting concentration limit thus spreading the risk over the sales ledger
- Factorability of the receivables – transaction characteristics, contract or financing terms that adversely impact the ability to factor, such as long warranties that the seller has to provide, contractual businesses (such as construction), the sale of perishable goods or the presence of stage payments. In general, the finance provider will exclude prohibited and restrictive categories of goods
- Receivables dilutions (for example, credit notes, offsets against invoices due for payment), mitigated by the security margin and advance ratio, through the establishment of a reserve (or margin) against the eligible discounted receivables
- Pre-existing security arrangements or bans on assignments, mitigated by waivers given by other secured parties or their removal or by taking additional security and completing the required perfection requirements
- Party-related risk mitigated by KYC/AML handled during the on-boarding procedures and subsequently in periodic reviewsLack of legal authority, mitigated by legal due diligence on the respective jurisdictions and the involved contractual parties
- Counter-trading mitigated by regular verification that the balance outstanding with the finance provider matches that on the buyer’s records
- Risks arising in the event of insolvency of the seller, such as ‘claw-back’, where a finance provider is aware of distress at the time of a receivable purchase, or in the case of co-mingling of funds in a general bank account. For the latter, there is mitigation through the use of a collection account in the name of the finance provider
- Fraud by the seller, for example by inflating the value of invoices or offering invoices without an underlying commercial transaction, mitigated by verification of the transaction and strong credit controls
- Double financing, mitigated by obtaining a security interest in the receivables, applying appropriate KYC procedures and perfecting the assignment of rights to the receivable
- Fraud by collusion between seller and one or more of its buyers leading to diversion of funds from meeting maturing obligations, mitigated by monitoring the financial health and management integrity of the client through maintaining contact and receiving regular management information to look for signs of a deterioration of the business and suspicious circumstances, and also mitigated, where necessary, by direct collections on the part of the finance provider
- Fraud by collusion between the seller and an employee of the finance provider, mitigated by internal controls and segregation of duties
- General operational risks resulting from multiple operational requirements to perfect ownership of receivables and undertake ongoing administration, mitigated by sound procedures, appropriate levels of automation and process controls
- Risks arising from incomplete or faulty perfection of jurisdictional requirements for assignments of title, particularly in a cross-border context, mitigated by appropriate due diligence.
All the above risks are also mitigated by a robust audit process of transactions, systems and controls and by regular reporting and monitoring, based on due diligence.
Transaction flow: illustrative only
Source: Global SCF Forum
The finance provider undertakes assessment of various aspects of the underlying transaction and agrees to provide the factoring service to the seller of goods and services (usually a credit limit is established for each buyer). The seller raises an invoice upon delivery of the goods/services rendered and sends a copy of the invoice or the invoice data set to the finance provider. After verification of the invoice copy or data set (or a suitable sampling regime), the finance provider advances a percentage (usually around 80%) of the value of the invoice to the seller. On due date, the buyer pays the outstanding invoice to the finance provider who in turn pays the remaining value of the invoice to the seller, less agreed fees and discount as applicable. The finance provider is responsible for reminder and collection procedures. The discount and other fees are payable according to the terms of the factoring agreement.
- Growth of business for the seller on open account terms
- Credit risk coverage in non-recourse factoring as the finance provider will pay normally 100% of the credit covered receivables if the buyer defaults in its payment
- Working capital optimisation for the seller without increasing balance sheet leverage (subject to accounting treatment in the relevant jurisdiction)
- Improved payment terms for the seller
- Finance and liquidity availability for sellers with limited credit availability from traditional banking sources
- Sales ledger management and collection of receivables as part of the service frees up the seller’s resources, and may offer improved debtor management
- Improved stability of the supply chain and reduced risk of supply chain disruption.
Such financings are typically offered by one finance provider, although in the event of very large amounts distribution techniques may be used.
Confidential or Non-Notification/Disclosed; Domestic/International; Recourse/Non-recourse; Whole Turnover/Selective.
The variations described below do not represent a separately defined technique but are common variations of the factoring technique defined above:
The buyer is situated in the same country as the seller. Country-specific rules or regulations may apply due to the domestic character of the transaction which would affect the relationship between the finance provider, the buyer and the seller.
- The buyer is situated in a different country from the seller. Country-specific rules or regulations may apply due to the international character of the debt which could affect the relationship between the finance provider, the buyer and the seller.
- For this reason, often two factors are involved, one in the buyer’s country (known as the ‘Import Factor’) and one in the seller’s country (known as the ‘Export Factor’). The two factors establish a contractual or correspondent relationship to service the buyer and the seller respectively (called the ‘Two-Factor-system’).
Typically, the two factors use an established framework such as the General Rules for International Factoring (GRIF), provided by Factors Chain International (FCI) and by International Factors Group. Since 2 January 2016, FCI and IFG have been integrated into one organisation.
The finance provider has recourse to the seller in the case of buyer default.
The finance provider has recourse to the seller in the case of buyer default.
Confidential or Non-Notification Factoring
The invoice bears no notice of assignment and the buyer is not aware of the factoring agreement between the seller and the finance provider.
The debt verification is carried out by the finance provider in the name of the seller so that the buyer is not aware of the factoring agreement. The buyer typically pays the outstanding invoice into a ‘trust’ or ‘escrow’ account. In some cases, the buyer may pay funds into a normal current account in the name of the seller, who acts as a collecting agent on behalf of the finance provider and undertakes to forward the funds immediately after collection to the same finance provider.
Disclosed or Notification Factoring
The invoice bears a notice of assignment and the buyer is notified of the assignment of the receivables. The buyer pays the outstanding invoice to the finance provider to discharge the obligation.
Selective or Spot Factoring
In Selective Factoring, the seller or finance provider selects a range of invoices to be assigned to the finance provider, identifiable by a common feature, such as buyer name, governing law of the receivables, and production segment among others. Spot factoring involves the factoring of an individual invoice.
The seller communicates the outstanding balance of its receivables ledger to the finance provider, which finances a percentage of the amount available to the seller by selecting invoices from specifically identified buyers. The funds available to the seller are adjusted based on the outstanding value of the sales ledger and further adjusted for a security margin. This use of the expression of Invoice Discounting is akin but not identical to Receivables Discounting, which also has a synonym Invoice Discounting. The usage of the term Invoice Discounting consequently varies as a matter of detail.