Factors to consider for Factoring

One of the crucial tasks a manager has to perform is to determine how to fund the company’s day-to-day operations. Hereby, the manager can generally rely on two sources of funds, which are existing: cash or credit. But cash is a scarce resource and potentially should be retained for other uses, such as for investments and servicing debt. Credit, on the other hand, is often a favoured alternative given its flexible nature, as well as the tax deductibility of its interest. While term loans and credit facilities remain a popular form of financing they are not the only financing tools, which can be regularly found on a companies’ balance sheet. Factoring, for instance, is one of the most widely spread alternatives to traditional lending.

Asset-Based Lending vs. Factoring (Accounts Receivable Financing):

Asset-Based Lending (ABL) predominately occurs as either a term loan or a credit facility, whereby the credit limit is generally determined based on the company’s assets. Inventory, accounts receivable and machinery and equipment pose as collateral for securing a loan or credit facility for the lender. However, the key distinction to factoring is that you do not sell your assets but borrow against them.

Factoring (also called receivables financing) is generally looked upon as a tool for cash flow optimisation. It involves, at least, three parties: The company selling its receivables, the company’s client owing the receivables (the debtor) and the factoring company (the factor). The nature of the factoring process is that of a financial transaction whereby the company sells its accounts receivable to the factor in exchange for an upfront cash payment on their receivables, usually around 90%, rather than having to await the full payment term. The factor then collects payment from the debtor and pays out the remaining 10% less their factoring fee to the initiating company. Generally, we can distinguish between two types of factoring:

Recourse factoring, being the most common form of receivables financing, is when a company engages in a factoring agreement where it must ultimately buyback any invoices that the factoring company was unable to collect. Hence, you as the initiator bear the sole risk of any outstanding unpaid invoices.

Non-recourse factoring, on the other hand, means that the factor takes on the risk of non-collection by the initiator. Hence, in theory, non-recourse factoring is close to risk-free for the initiating company. However, in practice, the situations determining non-payments (e.g. bankruptcy vs. momentary failure to pay) under these factoring agreements tend to be very specific and depending on the exposure taken on by the factor will be reflected in the factoring fee accordingly.

Also, there is a third form of factoring that can be sometimes found called reverse factoring. Opposed to conventional factoring, whereby a company tries to attain financing on their receivables, reverse factoring is initiated by the ordering party (the customer) to help its suppliers finance its receivables more easily. Given the nature of the process, reverse factoring is sometimes also referred to as client confirming or supply chain financing and has the great advantage that the supplier will usually be granted a lower interest rate than under a recourse or non-recourse factoring agreement.

The key distinction between a term loan or credit facility and factoring is that with factoring you gain an advance on your receivables by selling them to a factor whereas with traditional financing you borrow against the company’s assets. Both financing solutions will provide cash however ABL tends to be used more for e.g. the replacement or purchase of new equipment, while factoring is typically more related to basic working capital in industrial companies. In general, factoring tends to be faster than ABL and does not accumulate debt that requires monthly payments making it a more flexible and scalable financing solution. On the other hand, the amount you can draw from factoring tends to be much more volatile than traditional lending given the implications that seasonal patterns can have on the company’s accounts receivable balance. Hereby, ABL offers a more stable solution as the loan or credit line will usually be drawn on basis of the net asset value of the company, which is less prone to fluctuations than its receivable balance. In conclusion, both forms of financing pose attractive properties when faced with funding restraints, but it remains in the hands of the manager to choose wisely for each respective case to optimise the company’s cash flow.