Factoring is a financial tool that provides the seller of goods (client) with an advance against the accounts receivable. It improves liquidity, leads to better working capital management, and is also easier to obtain than traditional bank finance, especially for small and medium enterprises.
There are various types of factoring in financial services, and businesses can choose the one most suitable for them based on the exigencies of the businesses; factors like collateral, location of the factoring services, payment terms & the track record of the company providing the factoring services .
Recourse and Non-recourse Factoring
Under recourse factoring, the factor does not assume the credit risk or the risk of default by the customer. Credit risk is the risk of customers defaulting on their payment obligation. If the customer does not pay the dues on the due date, the factor will seek recourse against the client and exercise the right to recover the amount from the client. The factor provides sales ledger management services; however, the client bears the credit risk.
In non-recourse factoring, the factor bears the credit risk in addition to providing other services. Thus, even if the customer defaults on the due date, the factor cannot claim the amount back from the client. Naturally, the fees charged for non-recourse factoring services are higher than those for recourse factoring as they involve the cost of bearing the risk of non-payment by the customer.
The pricing in the case of non-recourse factoring tends to be on the higher side. We have compiled the difference between recourse and non factoring in an earlier post.
In full-service factoring (also known as full factoring), the factor performs a full range of services, including maintaining a sales ledger, sending regular statements of accounts to the client, collection of receivables, and credit control - gauging the creditworthiness of the customer, deciding credit limits and credit insurance for bearing the credit risk.
Full-service factoring is also known as Old Line Factoring. Businesses prefer it as it eases pressure on the accounting division and frees up the company's scarce resources, which can be put to optimal use. Given the entire gamut of services, this type of factoring charges the highest rates for services. Beyond the discount charges (interest charges), the administrative cost of factoring ranges between 0.5% to 2.5% of receivables.
Domestic and Export Factoring
Domestic factoring involves three parties - the client (the seller), the customer (the buyer) and the factor (the financial entity). All the parties are located in the same region. Domestic factoring is also far easier to operate and execute since cultural, legal and trade barriers between the trading parties are more or less similar.
In sharp contrast, factoring solutions for export transactions requires a much more deeper skill set, understanding of international trade processes, and a strong global presence and network of buyers and sellers.
In export factoring there may also be an additional party - the import factor (factor located in the customer’s region) in addition to the client, the customer, and the export factor (in the client’s region). The import factor is responsible for services like determining creditworthiness and credit limit for the customer and collecting money from the customer on the due date and remitting it to the export factor.
Spot versus Regular Factoring
Spot factoring is when the client and the factor enter into a factoring arrangement for one single specific transaction.
Under the factoring arrangement, the factor and the client have an ongoing relationship. Regular factoring usually has an approved limit. The client can draw an advance amount based on the issued invoices up to this limit. Usually, a factor prefers regular factoring and perceives it to be less risky than a spot factoring arrangement.
Maturity and Advance Factoring
Also referred to as wholesale factoring as the supplier that avails maturity factoring typically operates in the capacity of a wholesaler in the market.
Maturity factoring is also known as collection factoring. Under this type of factoring, the factor collects dues from the customer. It passes the agreed upon share to the client usually on the maturity date of each month's sales invoices.
Sometimes the due date can be a fixed date, usually pre-decided, based on the average payment period taken by the supplier.
The factor takes care of everything related to bookkeeping, collecting, and recording of payments over time. Maturity factoring can be with or without recourse as per the terms and conditions of the contract.
Under advance factoring arrangement, a factor pays 75% - 90% (as per the contractual agreement) of factored receivables in advance to the client. This is done within a couple of working days from the presentation of the invoice to the factor.
The balance amount is paid on the guaranteed payment date on the realization of money from the customers, as per the contract.
The factor charges an agreed rate of interest for the advance payment made to the business. This interest is called a discount.
This discount charge depends upon various factors like short-term rate, turnover, the financial standing of the business, etc.
The business may opt for advance factoring if it needs immediate liquidity. However, if there is no immediate requirement of cash for invoices, then the business may opt for maturity factoring. Both types of factoring can be with or without recourse.
Disclosed and Non-disclosed Factoring
Disclosed factoring is also called bulk factoring or notified factoring. Under disclosed/bulk/notified factoring, the factor immediately discloses the fact of assignment of debt by the client to the buyer/importer.
The supplier places a notice on the buyer/importer’s invoice instructing them to make payment directly to the factor. This is usually referred to as the Notice of Assignment.
In a non-notification or non-disclosed factoring or confidential factoring deal, the buyer is completely unaware of the vendor’s financing arrangement with the factoring company.
The factor only provides an advance against invoices. The customer makes the payment directly to the client without being aware of the factoring agreement.
The client collects the payment from the customer and remits the due amount to the facto. Some businesses prefer this type of factoring as it allows businesses to deal directly with the customers and establish a better relationship.
Bank Participation Factoring
In most factoring solutions, not 100% of the invoice value is paid out to the supplier. The factor typically keeps a buffer amount and advances upto 80% of the invoice value.
While this is generally acceptable to most exporters or suppliers, sometimes, suppliers need to tap into a wider pool of resources to combat a working capital crunch.
This is where bank participation factoring plays in wherein, the bank will fund a certain % of the unadvanced amount to the supplier.
For example: If company Y has factored 80% of its invoice or Rs 100,000 with Factor X, factor X would have advanced only Rs 80,000, the rest will be paid out when the factor receives the payment from the buyer.
In such a case, the factor can enter into a separate agreement with a bank and avail a loan, which is typically at a % of the unadvanced amount (Rs 20,000)
Limited factoring, also known as selective factoring, is when the factor manages selective invoices of the client and not all. The factor discounts the selected invoices on a merit basis and remits cash collected only against the selected invoices.
The selection may be based on a set of criteria determined by the factor, including credit risk assessment, cost considerations, processing capacity, etc.
Sometimes the factoring may be buyer based. In buyer based factoring, the factor maintains a list of the buyers (customers) whose receivables would be factored without recourse to the seller.
Supplier Guarantee Factoring
This type of factoring is also known as ‘drop shipment factoring’ or vendor guarantee factoring or supply chain facto. Supplier guarantee factoring is a tri-party agreement that involves one additional party - the borrower’s supplier.
The supplier could be a supplier of raw material for a huge order, or the client could be a distributor. The factor guarantees to pay the supplier once the shipped goods are accepted by the borrower’s buyer.
The funds generated from factoring the invoice are directly paid to the supplier. The supplier is paid out of the client’s future receivables. When the factor receives payment from the customer on the due date, they deduct the fees and the charges and remit the profit to the client.
Thus, the factor plays a dual role in this type of transaction - giving a guarantee for payment to the supplier and, providing the factoring services to the business.
The biggest benefit of this type of factoring is that companies can undertake new business opportunities that were not previously achievable, due to a lack of available credit from suppliers.
This is a different kind of factoring that is initiated by the buyer or the importer. It is also called supply chain financing. The customer arranges the factor relationships such that the client gets invoice financed upfront. Sometimes even the fees for the same are borne by the customer.
Reverse factoring is usually seen in transactions where the customer is a medium-sized or a large entity, and the client is a small or medium enterprise.
With factoring, the client gets immediate liquidity which could be critical for business and the buyer gets more time to pay the invoice.
Although not exactly a type of factoring service, forfaiting is also another method of financing invoices, it is popularly used in industries that have a long turnaround time between order placement and delivery.
Also read this article to know more about the key differences between forfaiting and factoring.