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.

Factoring and Invoice Discounting: Working Capital Management Options 1 of 5 www.qfinance.com 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.

Factoring Example and the Cost of Factoring

Factoring represents a sale of accounts receivable to a financial institution, which acts as a factor. This may be a bank, or an independent factoring broker. There are three parties to this transaction: a client company (a producer that has provided services or produced goods, and issued invoices to its debtors, who need to pay invoices to the company under certain conditions); a debtor (the company that ought to pay the invoice to the producer in due time); and a factor that facilitates the transaction through buying the invoice from the client, and finances the amount over an agreed period.

Simple Illustration The factor purchases £100 from its client under a factoring contract. The client company (borrower) receives, from the factor, 70% of the value of the invoice minus interest and service fees, and minus a factoring commission of, say, 2%. The client receives the remaining 30% upon receiving the payment from its customer. The amount of £30 serves as a reserve amount, and is kept by the factor until the invoice is paid. At the beginning of the transaction, the factor advances £68 and acquires ownership of the whole receivable. When the invoice is paid in 31 days, the factor sends £30 to the client on day 31. The size of the reserve depends on the perceived risk of the client. There will be an additional cost, which will be the interest on the outstanding balance of receivables. The interest can be deducted at the beginning, at the same time as factoring the commission. The client company pays a commission fee for the factoring service to the factor, as well as interest for the period of financing. The factor bears the risk of non-paying customers. The factor buys the receivable at a discount, which ranges from 0.35% to 4%. The interest for factoring is usually 1.5 to 3 percentage points above the base rate, reflecting the overall risk of the transaction, as well as current market conditions. The rates are roughly equivalent to bank overdraft rates, and can occasionally be better.

Case Study

The Cost of Factoring: A Short Summary Background: The turnover of a client company is £750,000 per year, and debtors are taking an average of 50 days to pay on commencement of the factoring agreement. The factoring company provides the following conditions: Factoring commission: 1.25% Factoring interest: 7.0% pa Average credit period: 50 days Convention 360 days in a year Factoring commission cost: 1.25% x £750,000 £9,375 Factoring interest cost:

Factoring and Invoice Discounting: Working Capital Management Options 2 of 5 www.qfinance.com (£750,000 # £9,375) × 7% × 50 ÷ 360 £7,200 Total factoring costs: £16,575 The total cost of funding over the period of 50 days is £16,575. This needs to be compared with other funding options (e.g. bank loan) for optimization. (Adapted from Factoring solutions: www.factoringsolutions.co.uk, accessed December 10, 2008.)

Regulation of the Industry

Company cash flow, and its financial health, are very much affected by performance of its short-term assets. In this regard, the way factoring is arranged and managed is extremely important, as it directly affects the cash flow and financial health of a client company. Companies, therefore, need to pay close attention to choosing a good quality factor, because selecting the wrong factor can have a damaging effect on the company. “Unfortunately, there isn’t any regulation of factoring companies, and equally unfortunately, as any knowledgeable factoring insider will tell you, the industry is badly in need of regulation, as currently the factoring companies exercise far too much power, and on the occasions when they abuse that power, the poor client has no one to complain to.” (Source: www.factoring-broker.org.uk, accessed December 10, 2008.) Factoring is a complex, long-term agreement that could have major effects on the management and development of the client company. It is, therefore, advisable to take legal advice on the legal and financial implications of factoring.

Invoice Discounting

Invoice discounting is another policy used by firms to speed up collection of receivables. Invoice discounting is an alternative way of drawing money against a company’s receivables, i.e., issued invoices. In this case, the business retains control over the administration of receivables. It provides a cost-effective way for profitable businesses to improve their cash flow. There are two parties to this transaction: the client company and the invoice discounter. This service is provided by banks and financial institutions to businesses that sell products or services on credit to other businesses. It is normally available to businesses with a proven track record, and annual turnover of at least £500,000, and is usually a long-term relationship between the business and the invoice discounter.

The Mechanics of Invoice Discounting The invoice discounter first checks the client company, its accounting, and production systems. It reviews the client’s accounting system, its customers, and its overall creditworthiness, and will then agree to pay a certain percentage of its total outstanding receivables. The client company pays a monthly fee and interest on the net amount advanced. Typical fees range from 0.2% to 0.5% of discounted receivables. These fees are less than factoring fees, because only the financing service is provided. “For example, if the invoice discounter agrees to advance 80% of the total owing, and the total of outstanding invoices is steadily changing, then so will the amount you receive. If the outstanding debt drops month on month, you must repay 80% of the fall in debt. If the debt rises month on month, you will receive 80% of the increase.” (Source: Adapted from Business Link, www.businesslink.gov.uk, accessed December 10, 2008.)

Short-Term Finance and Working Capital Management

Short-term finance consists of the management of short-term assets and liabilities. Both methods—factoring and invoice discounting—reduce the cash cycle in the business, and the need to finance short-term assets of

Factoring and Invoice Discounting: Working Capital Management Options 3 of 5 www.qfinance.com the company. The shortcomings of these methods are that if the factor is not a good-quality organization, the corporate client will suffer and have problems with cash flow. Lack of regulation in the industry may also be a problem in using factoring. Invoice discounting is less complex as the discounter provides only financing, while the company retains total control over its sales ledger. There are also many other services provided by the financial sector that can improve the use of cash in a company, including debt factoring, invoice factoring, and asset-based lending. The topic remains the same: turn the company’s unpaid invoices into cash that can be put to work immediately. An invoice- discounting facility grows with the volume of issued invoices. Therefore, there is no need to renegotiate funding or increase the overdraft facility to free business capacity in order to enable a quick reaction to market opportunities.

Making It Happen

Factoring services in particular are provided by many companies and therefore it pays to look around for the best deal. Financial companies usually provide both factoring and invoice discounting services. Factors are usually linked with bigger banks to provide secure funding. Some examples of providers of commercial finance and asset financing are provided in the next section.

More Info

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.

Websites: • Factoring Solutions, independent factoring firm: www.factoringsolutions.co.uk • HSBC, information on factoring: www.hsbc.co.uk/1/2/business/finance-borrowing/invoice-finance • Independent Factoring Brokers Association: www.factoring-broker.org.uk • Lloyds TSB, information on factoring: www.ltsbcf.co.uk/factoring • Royal Bank of Scotland, information on factoring: www.decision-finance.co.uk/ royal_bank_of_scotland_factoring.html • UK government-sponsored advice agency, Business Link: www.businesslink.gov.uk