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In "advance" factoring, the business owner sells his receivables in the form of invoice to the factor, who makes an advance of 70-85% of the purchase price of the receivable amount. The factor collects the full amount from the customer in due course and pays the balance amount due to the business owner after deducting his commission and other charges. In "maturity" factoring, the factor makes no immediate advance on the purchased accounts, but sees to it that the customer pays the invoiced amount within the stipulated time i.e. on maturity. However, if the customer fails to make payment within the stipulated time e.g. 30 days, the factor makes payment to the client and proceeds to collect the payment from the customer.
The three parties directly involved are: the one who sells the receivable, the debtor (the account debtor, or customer of the seller), and the factor. The receivable is essentially a financial asset associated with the debtor's liability to pay money owed to the seller (usually for work performed or goods sold). The seller then sells one or more of its invoices (the receivables) at a discount to the third party, the specialized financial organization (aka the factor), often, in advance factoring, to obtain cash.
The sale of the receivables essentially transfers ownership of the receivables to the factor, indicating the factor obtains all of the rights associated with the receivables. Accordingly, the factor obtains the right to receive the payments made by the debtor for the invoice amount and, in nonrecourse factoring, must bear the loss if the account debtor does not pay the invoice amount due solely to his or its financial inability to pay. 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 (seller) collects the accounts sold to the factor, as agent of the factor, also occurs.
There are three principal parts to "advance" factoring transaction: (a) the advance, a percentage of the invoice face value that is paid to the seller at the time of sale, (b) the reserve, the remainder of the purchase price held until the payment by the account debtor is made and (c) the discount fee, the cost associated with the transaction which is deducted from the reserve, along with other expenses, upon collection, before the reserve is disbursed to the factor's client. Sometimes the factor charges the seller (the factor's "client") both a discount fee, for the factor's assumption of credit risk and other services provided, as well as interest on the factor's advance, based on how long the advance, often treated as a loan (repaid by set-off against the factor's purchase obligation, when the account is collected), is outstanding. The factor also estimates the amount that may not be collected due to non-payment, and makes accommodation for this in pricing, when determining the purchase price to be paid to the seller. 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.
Accounts receivable discounting
Non-recourse factoring is not a loan. A lender decides to extend credit to a company based on assets, cash flows, and credit history. An interesting example of factoring is the credit card. Factoring is like a credit card where the bank (factor) is buying the debt of the customer without recourse to the seller; if the buyer doesn't pay the amount to the seller the bank cannot claim the money from the seller or the merchant, just as the bank in this case can only claim the money from the debt issuer (Farag, I. 2013). Factoring is different from invoice discounting, which usually doesn't imply informing the debt issuer about the assignment of debt, whereas in the case of factoring the debt issuer is usually notified in what is known as notification factoring. One more difference between the factoring and invoice discounting is that in case of factoring the seller assigns all receivables of a certain buyer(s) to the factor whereas in invoice discounting the borrower (the seller) assigns a receivable balance, not specific invoices. A factor is therefore more concerned with the credit-worthiness of the company's customers. The factoring transaction is often structured as a purchase of a financial asset, namely the accounts receivable. A non-recourse factor assumes the "credit risk" that an account will not collect due solely to the financial inability of account debtor to pay. In the United States, if the factor does not assume the credit risk on the purchased accounts, in most cases a court will recharacterize the transaction as a secured loan.
It is different from forfaiting in the sense that forfaiting is a transaction-based operation involving exporters in which the firm sells one of its transactions, while factoring is a financial transaction that involves the sale of any portion of the firm's receivables.
Factoring is a word often misused synonymously with invoice discounting, known as "Receivables Assignment" in American Accounting ("Generally Accepted Accounting Principles"/"GAAP" propagated by FASB) - factoring is the sale of receivables, whereas invoice discounting is borrowing where the receivable is used as collateral. However, in some other markets, such as the UK, invoice discounting is considered to be a form of factoring involving the assignment of receivables and is included in official factoring statistics. It is therefore 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..
Treatment under GAAP
In the United States, under the Generally Accepted Accounting Principles receivables are considered sold, under Statement of Financial Accounting Standards No. 140, when the buyer has "no recourse,". Moreover, to treat the transaction as a sale under GAAP, the seller's monetary liability under any "recourse" provision must be readily estimated at the time of the sale. Otherwise, the financial transaction is treated as a loan, with the receivables used as collateral.
When a non recourse transaction takes place, the accounts receivable balance is removed from the statement of financial position. The corresponding debits include the expense recorded on the income statement and the proceeds received from the factor.
Factoring's origins lie in the financing of trade, particularly international trade. It is said that factoring originated with ancient Mesopotamian culture, with rules of factoring preserved in the Code of Hammurabi.
Factoring as a fact of business life was underway in England prior to 1400, and it came to America with the Pilgrims, around 1620. It appears to be closely related to early merchant banking activities. The latter however evolved by extension to non-trade related financing such as sovereign debt. Like all financial instruments, factoring evolved over centuries. This was driven by changes in the organization of companies; technology, particularly air travel and non-face to face communications technologies starting with the telegraph, followed by the telephone and then computers. These also drove and were driven by modifications of the common law framework in England and the United States.
Governments were latecomers to the facilitation of trade financed by factors. English common law originally held that unless the debtor was notified, the assignment between the seller of invoices and the factor was not valid. The Canadian Federal Government legislation governing the assignment of moneys owed by it still reflects this stance as does provincial government legislation modelled after it. As late as the current century the courts have heard arguments that without notification of the debtor the assignment was not valid. In the United States, by 1949 the majority of state governments had adopted a rule that the debtor did not have to be notified thus opening up the possibility of non-notification factoring arrangements.
Originally the industry took physical possession of the goods, provided cash advances to the producer, financed the credit extended to the buyer and insured the credit strength of the buyer. In England the control over the trade thus obtained resulted in an Act of Parliament in 1696 to mitigate the monopoly power of the factors. With the development of larger firms who built their own sales forces, distribution channels, and knowledge of the financial strength of their customers, the needs for factoring services were reshaped and the industry became more specialized.
By the twentieth century in the United States factoring was still the predominant form of financing working capital for the then high growth rate textile industry. In part this occurred because of the structure of the US banking system with its myriad of small banks and consequent limitations on the amount that could be advanced prudently by any one of them to a firm. In Canada, with its national banks the limitations were far less restrictive and thus factoring did not develop as widely as in the US. Even then factoring also became the dominant form of financing in the Canadian textile industry.
Today factoring's rationale still includes the financial task of advancing funds to smaller rapidly growing firms who sell to larger more creditworthy 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 (i.e., accounts receivable ledger); daily management reports on collections; and, make the actual collection calls. The outsourced credit function both extends the small firms 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 backoffice functions. More importantly, the services insure the entrepreneurs and owners against a major source of a liquidity crises and their equity.
In the latter half of the twentieth century the introduction of computers eased the accounting burdens of factors and then small firms. The same occurred for their ability to obtain information about debtor’s creditworthiness. Introduction of the Internet and the web has accelerated the process while reducing costs. Today credit information and insurance coverage is available any time of the day or night on-line. The web has also made it possible for factors and their clients to collaborate in realtime on collections. Acceptance of signed documents provided by facsimile as being legally binding has eliminated the need for physical delivery of “originals”, thereby reducing time delays for entrepreneurs.
With these advances in technology, invoice factoring providers usually adapt to a specific industry. This often affects additional services offered by the factor in order to best adapt the factoring service to the needs of the business. An example of this includes a recruitment specialist factor offering payroll and back office support with the factoring facility; a wholesale/distribution factor may not offer this additional service. These differences can affect the cost of the facility, the approach the factor takes when collecting credit, the administration services included in the facility and the maximum size of invoices which can be factored.
By the first decade of the twenty first century a basic public policy rationale for factoring remains that the product is well suited to the demands of innovative rapidly growing firms critical to economic growth. A second public policy rationale is allowing fundamentally good business to be spared the costly management time consuming trials and tribulations of bankruptcy protection for suppliers, employees and customers or to provide a source of funds during the process of restructuring the firm so that it can survive and grow.
Since the 2007 United States Recession one of the fastest growing sectors in the factoring industry are real estate commission advances. Commission advances work the same way as factoring but are done with licensed real estate agents on their pending and future real estate commissions.
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 2 factors:
- The extent cash flow can change,
- 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 (cash balances or a factor) 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:
- is the cash balance
- is the average negative cash flow in a given period
- is the [discount rate] that cover the factoring costs
- is the rate of return on the firm’s assets.
Invoice payers (debtors)
Large firms and organizations such as governments usually have specialized processes to deal with one aspect of factoring, redirection of payment to the factor following receipt of notification from the third party (i.e., the factor) to whom they will make the payment. Many but not all in such organizations are knowledgeable about the use of factoring by small firms and clearly distinguish between its use by small rapidly growing firms and turnarounds.
Distinguishing between assignment of the responsibility to perform the work and the assignment of funds to the factor is central to the customer/debtor’s processes. Firms have purchased from a supplier for a reason and thus insist on that firm fulfilling the work commitment. Once the work has been performed however, it is a matter of indifference who is paid. For example, General Electric has clear processes to be followed which distinguish between their work and payment sensitivities. Contracts direct with US Government require an Assignment of Claims which is an amendment to the contract allowing for payments to third parties (factors).
Risks to a factor include:
- Counter party credit risk related to clients and risk covered debtors. Risk covered debtors can be reinsured, which limit the risks of a factor. Trade receivables are a fairly low risk asset due to their short duration.
- External fraud by clients: fake invoicing, mis-directed payments, pre-invoicing, not assigned credit notes, etc. A fraud insurance policy and subjecting the client to audit could limit the risks.
- Legal, compliance and tax risks: large number of applicable laws and regulations in different countries.
- Operational risks, such as contractual disputes.
- Uniform Commercial Code (UCC-1) securing rights to assets.
- IRS liens associated with payroll taxes etc.
- ICT risks: complicated, integrated factoring system, extensive data exchange with client.
- "Factor". Investopedia. Retrieved 27 July 2013.
- 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
- J. Downes, J.E. Goodman, "Dictionary of Finance & Investment Terms", Baron's Financial Guides, 2003; and J.G.Siegel, N.Dauber & J.K.Shim, "The Vest Pocket CPA", Wiley, 2005.
- "Why Do Factoring Companies Hold a Reserve?". Frequently Asked Questions. Commercial Capital LLC. Retrieved 27 July 2013.
- J.G.Siegel, N.Dauber & J.K.Shim, "The Vest Pocket CPA", Wiley, 2005.
- Please Refer to the Wiki article, forfaiting, for further discussion on cites.
- BCR Publishing, "The World Factoring Yearbook", UK Section.
- ABFA, , Differences between factoring and invoice discounting.
- This means that the factor cannot obtain additional payments from the seller if the purchased account does not collect due solely to the financial inability to pay of the account debtor; however, "quality recourse" still exists. In other words, the nonrecourse factor who assumes credit risk bears the credit loss and incurs bad debt if a purchased account does not collect due solely to financial inability of the account debtor to pay.
- Memos, Financial. "Accounting Treatment for Factoring with and without recourse". Financial Memos. Retrieved 23 November 2013.
- Four Centuries of Factoring; Hillyer, William Hurd; Quarterly Journal of Economics MIT Press 1939; D. Tatge, D. Flaxman & J. Tatge, American Factoring Law (BNA, 2009)
- Bankers and Pashas: International Finance and Economic Imperialism in Egypt; Landes, David S.; Harper Torchbooks 1969
- Factoring, Jones, Owen; Harvard Business Review February 1939 and Factoring as a Financing Device, Silverman, Herbert R.; Harvard Business Review, September 1949; D. Tatge, D. Flaxman & J. Tatge, American Factoring Law (BNA, 2009)
- Silverman, Herbert R.; Harvard Business Review, September 1949
- Silbert HBR Jan/Feb 1952
- Good Capitalism Bad Capitalism and The Economics of Growth and Prosperity; Baumol, William J., Litan, Robert E., and Schramm, Carl J. Yale University Press 2007
- EU Federation for Factoring and Commercial Finance
- The return on its investment can be estimated by looking at its Net Income Relative to its Total Assets
- William J. Baumol, The Quarterly Journal of Economics, (Nov, 1952), 545-556.
- 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 (more cash flows out than in).
- Alastair Graham; Brian Coyle (2000-03-01). Framework for: Credit Risk Management. Global Professional Publishi. pp. 1–. ISBN 978-1-888998-73-3.
- Lalit Raina; Marie-Renée Bakker; World Bank (2003). Non-Bank Financial Institutions and Capital Markets in Turkey. World Bank Publications. pp. 79–. ISBN 978-0-8213-5527-5. Retrieved 13 March 2013.
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