Invoice financing is ideal for today’s exceedingly credit-driven international trade landscape. Invoice financing options such as factoring and discounting enable sellers to leverage their trade receivables to maintain healthy working capital numbers.
As a result, invoice financing is a key driver of business continuity in several organizations. Invoice financing also allows buyers time to pay for their purchases.
Factoring is a form of invoice financing that offers an incredibly simplified solution for businesses, as it offers a quick injection of funds and allows them to focus on their core operations.
By definition, factoring is a financing option in which financiers — known as factoring companies — provide funds to sellers in exchange for their trade receivables on the basis of invoices raised. The funds provided are a percentage (generally in the 80-90% range) of the amount specified on the receivables.
Later, when the buyers pay this amount to the factoring companies, the latter release the remainder of the invoice money to the sellers. Factoring companies retain a cut of this amount as their commission. There are many types of factoring solutions, recourse & non-recourse factoring being two of the more common ones.
In most cases, factoring companies may provide either recourse or non-recourse factoring solutions to businesses. The main difference between these two options is the willingness (or the lack thereof) of a factoring company to absorb the credit risks of a seller.
What Does Recourse Factoring Mean?
Factoring companies who provide recourse factoring do not absorb a seller’s risk of bad debts. Unlike the non-recourse factoring option, such companies will recover their money from a seller even when the seller's customer cannot pay for their purchases. So, effectively, the credit risk of trade receivables falls squarely on the seller in the case of the recourse factoring financing avenue.
The factoring agreement between a business and a factoring company dictates how many days after the due date for payment must the seller refund the advance provided to them in exchange for their trade receivables.
Even if the business fails to refund the advance amount, they are legally obligated to pay the factoring company's fees and interest (discount charge), if any.
Primary Benefits of Recourse Factoring
Despite its seemingly ruthless nature, recourse factoring is a resourceful financing alternative for businesses. Some of the reasons for that are enlisted here:
Low costs compared to non-recourse factoring: Businesses expose themselves to bad debt risks by choosing the recourse factoring option. Therefore, factoring companies price it lower than its non-recourse counterpart. This makes recourse factoring a cheaper alternative than most other invoice financing options available to businesses. Its lower fee and interest rates make recourse factoring a more alluring option for businesses needing immediate liquidity.
No trace of debt in financial records: A factoring-based inflow of money does not classify as a loan and is treated as a credit advance.
Low turnaround time: Factoring companies providing recourse factoring do not conduct several assessments to evaluate an organization’s credit score. This makes the process of getting funds through this option much quicker.
Challenges of Recourse Factoring
As one can expect, recourse factoring is not viable for all organizations and situations. Here’s why:
High risk of bad debts: Recourse factoring enables buyers to default on their invoice payments at the cost of sellers. The penalties and repayments in such cases can take a toll on a seller’s income and bank accounts.
High repayment amounts for sellers: If invoices remain unpaid and sellers need more time to pay back the factoring company, the seller then has to pay higher prices in interest rates and fees. Thus, the penalty of payment default can get severe in the case of recourse factoring.
An Example of Recourse Factoring
A company ABZ Ltd has its net trade receivables valued at USD 300,000. On 30th April, the company, situated in Los Angeles, California, entered into a factoring agreement with a company named CRZ Ltd, which is also LA-based. The fee structure for the factoring agreement is 10%. The LA-based financier retains some assets from ABZ Ltd in case bad debts arise in the future. The cash ABZ Ltd receives from the factoring company is USD 240,000 (80% of the invoice valuation). Once the due date of receiving the payment arrives, the amount of 240,000 must be paid to the factoring company, also commonly known as the factor. In case ABZ Ltd fails to do so, CRZ Ltd retains the company's assets and its 10% fees. Additionally, ABZ Ltd must pay USD 240,000 plus penalties to the financier for the payment default.
Non-Recourse Factoring Meaning
This financing alternative involves a factoring company absorbing the bad debt risk of a subscribed seller. However, while factoring companies offering this alternative accept the risks, they do not insure against unpaid debts that arise due to disputes.
A factoring company takes control and accountability for pursuing its client's customer for payment. Additionally, the factoring company can take legal action against the client’s customer if necessary.
Primary Benefits of Non-Recourse Factoring
Due to an obvious reason, non-recourse factoring presents an appealing financing avenue for businesses. Some of its main benefits include:
More forgiving than recourse factoring: In the case of non-recourse factoring, a business is not legally obligated to repay the invoice amounts to a factoring company if its customer defaults on paying against its trade receivables. This reduces the bad debt risk aspect of this financing avenue.
Low risk of business continuity breakdown: Businesses do not have to break open their financial structure to repay a factoring company if their customer becomes a bad debtor. This allows them to keep their mission-critical operations running unabated.
Challenges of Non-Recourse Factoring
Despite its appeal, non-recourse factoring comes with its share of issues, some of which include:
More expensive than recourse factoring: Non-recourse factoring keeps sellers impervious to bad debt risks when their customers default on invoice repayments. At the same time, this option exposes factoring companies to those very risks. To compensate for that, the factoring companies price the non-recourse factoring solution higher than the recourse factoring option.
More difficult to obtain for businesses: Businesses need to maintain a fairly healthy credit score to secure non-recourse funds from a factoring company. Moreover, factoring companies generally have minimum requirements for companies to be eligible for the factoring solution. These requirements can be based on minimum shipments, minimum annual turnover etc.
Maintaining perfect creditworthiness is nearly impossible for any business — especially MSMEs — such businesses may never be able to avail funds through this avenue.
Low confidentiality in transactions: In cases of non-recourse factoring, where a factoring company will have to bear the losses in the event of non-payment, The factoring company enlists certain safeguards to protect its interests. For instance, most factoring companies insist that the payments should be made to the factoring company directly. In such a case, a business's customer will know that a third-party entity is involved in its trade transaction with its seller. This may strain the relationship between the customers and sellers in the long run.
An Example of Non-Recourse Factoring
In the above example, if ABZ Ltd does not get the invoice money from its customer, KLM Ltd, also based in LA, they will still not face bad debt risks or legal trouble at the hands of the factoring company. On the other hand, CRZ Ltd may pressure KLM Ltd to pay the amount. CRZ Ltd may also take legal action against KLM Ltd for the latter’s failure to pay the amount it owes to the former.
Why Would a Company Factor its Trade Receivables With vs. Without Recourse?
Whether to choose recourse factoring or non-recourse factoring as a financing option depends on several criteria, such as eligibility, costs, operational priorities and the nature of the organization’s customer relationships. Some important parameters to consider include:
Whether the Organization is Eligible for Non-Recourse Factoring
If cost and creditworthiness are taken out of the equation, most businesses may choose non-recourse factoring due to its relatively risk-free nature. However, with those two factors in consideration, not all businesses are eligible for non-recourse factoring.
Moreover, the time needed for credit score assessment (the checking may even include a company’s debtors’ credit scores) and the overall cost of non-recourse factoring make recourse factoring a much quicker and practical option for a majority of businesses, even those with decent credit scores.
Whether the Costs are Worth the Benefits
Non-recourse factoring is more expensive than recourse factoring simply because the factoring company is taking on customer non-payment risks that otherwise belong to the business. If a business has a significant chunk of customers that pay on time, then the additional costs that come with non-recourse factoring may not be worth it. In such cases where bad debts are low, recourse factoring is a better financing option.
With non-recourse factoring, businesses don’t have to pay the factoring company back until their customers make payments against invoices. This means that cash not received is not payable to the factoring company. With this factoring option, cash flow remains healthy for the business.
However, with recourse factoring, a business has to pay back the factoring company irrespective of whether their customers have made payments against invoices or not. This means that cash not received is still payable to the factoring company.
This could create an unhealthy cash flow situation for the business, especially if several of their customers fail to make payments or delay them. Additionally, if a business cannot pay the factoring company on time due to cash flow issues, its liability increases even more, further worsening the cash flow situation.
Recourse Vs Non-Recourse Factoring
Knowing the key distinction points between recourse and non-recourse factoring helps businesses make the right selection between the two alternatives. Here are some distinctions:
Which Type of Factoring is Suitable for a Business?
Before selecting a factoring company and type, a business can consider the following essential aspects — factoring costs, discount rates, the turnaround time for liquidation of trade receivables, the reputation and history of the company, the willingness to absorb credit risks, creditworthiness, and whether a business undertakes payment recovery from its customers or not.
Based on these, and several other factors, businesses can choose the factoring company of their choice. Normally, businesses with credit scores on the higher side and with no payment recovery personnel can opt for non-recourse factoring. On the other hand, (generally smaller) businesses who need money on an emergency basis to keep themselves afloat and their working capital always in the green can opt for recourse factoring as it is not only faster to get but also cheaper compared to non-recourse factoring.
Essentially, businesses need to prioritize their needs and select the option that helps them meet their objectives.
What is the Accounting Treatment for Recourse and Non-Recourse Factoring Transactions?
Let’s assume the case of a non-recourse factoring transaction at the day in which the trade receivables to the tune of $1,00,000 are transferred to the factor. In such a case, $100,000 is the accounts receivable that is now transferred to the factor.
Factoring companies disburse only a portion of the total receivables and subtract a fee from the total receivables. So a factoring company may payout around $95,000 & retain $5,000 as a factoring fee that is an expense assumed by the business.
The entry looks something like this :-
At the time of publishing this article, we couldn’t ascertain the exact accounting treatment based on accounting system. Please make sure to contact your Chartered Accountant before making any accounting treatments based on this information.
Frequently Asked Questions
Here are some of the most pressing questions business owners generally have regarding factoring and its types:
Is factoring secured or unsecured?
Normally, invoice factoring is self-secured. Therefore, businesses do not have to put up any collateral or personal guarantees because they liquidate their outstanding invoices.
In which type of factoring does the factor not bear the credit risk?
The factoring company, also known as the factor, does not bear the credit risk in recourse factoring.
What is the difference between recourse and non-recourse loans?
A recourse loan holds the borrower personally accountable. All other kinds of loans are considered to be non-recourse in nature. In essence, recourse loans allow lenders to collect what is owed for the debt even after they've taken control of the loan seeker's collateral (credit cards, homes, and other assets).
What is non-recourse export factoring?
Non-recourse export factoring is a financial solution to address the requirements of export companies working with their customers on deferred payment basis. Such loans are generally 100% protected from credit risks and are not secured in nature. On the flip side, getting funds necessitates high creditworthiness in businesses.