In business, credit sales have become the norm in modern-day transactions. However, cash flow is a very important factor in business. Sometimes you need the money a lot sooner than the agreed date of payment. This can happen for various reasons but most commonly it is market conditions that dictate the payment terms. Operating in a market where payment terms are usually net 30, that is, where payment occurs 30 days after the transaction date you would find it hard to demand cash payments unless your product was significantly cheaper or sufficiently superior to other offers on the market. This is rarely the case. For many, the solution is invoice factoring which has two main alternatives which are recourse factoring and non-recourse factoring. Firstly what is invoice factoring?
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What Is Invoice Factoring?
Invoice factoring which is sometimes referred to as invoice financing is a process through which a business which has provided goods or services and is awaiting payment for said goods or services sells the invoice to a financial institution. The financial institution will pay the business for the right to receive the payment when it matures in return the financial institution pays the invoice owner money on the spot. However, they do not pay the full amount on the face of the invoice. They pay a discounted amount compared to face value. The degree of the discount is called a factor hence the term factoring. Before we define recourse factoring and non-recourse factoring we need to understand how the factor is arrived at.
Where Does The Factor Come From?
When you approach a invoice factor they will analyse the quality of the invoice. Quality, in this case, is simply the likelihood of the invoice to be honoured and how much time they must wait for the invoice to be honoured. This likelihood is determined by the debtor on the invoice, the nature of the invoice and previous experience with your business in the case of an ongoing agreement. Of course, the debtor is important because they ultimately are responsible for making the payment. If they have a bad record when it comes to payments they are deemed unlikely to pay and this increases the discount factor. Similarly, the nature of the business being done on the invoice can determine the discount factor. Invoices for regular recurring business are favourable over one-off invoices. Previous experience with your business is also important because you extend credit to your customers and the process through which you choose who to extend credit to will determine how reliable your debtors are. If you have tight credit control this will work in your favour and reduce the discount factor. In advanced arrangements, the invoice factor may take over the entire accounts receivables book of a business. Now that we understand these factors we can look at the differences between recourse factoring and non-recourse factoring.
Recourse factoring is an agreement between the client business and the invoice factor in which the client is required to buy back the unpaid bills receivable from the factor. The factor will pay the business for its invoices as stated above. In recourse factoring, upon the maturity of invoices, the client will pay back the factor for any invoices that have not been honoured. Let’s illustrate this with a simple example. Business A has 10 invoices worth $100 each and approaches Factor Z to buy the invoices. They all have a 30 day maturity period. Factor Z buys the invoices at a 5% discount, paying $95 for each invoice hence $950. After the 30 days, it emerges that 8 of the 10 invoices were paid in full with no payment received for the other two. Business A would pay $200. The $190 it received for the two invoices that were not paid up plus the $10 ($5 each). This $5 per invoice would be recognised a cost of borrowing.
Recourse factoring offers a great advantage to the factor because the risk of unpaid invoices rests with the client business. The invoice factor bears no risk and as such the discount factor tends to be lower on the invoices. This is an advantage to the client business which receives more cash upfront for invoices that they can immediately plough back into business operations. The obvious disadvantage of recourse factoring to the client is the advantage of the factor, the business maintains the risk of the invoice going unpaid.
Under non-recourse factoring, the client and the factor enter into an agreement where the factor shall bear the obligation of absorbing those bills receivable which remain unpaid. Using our earlier example Business A will receive $950 but if any of the invoices remain unpaid after maturity as in the example the risk and the loss remains with the factor. This, however, comes at a cost to the client. Non-recourse factoring usually comes with a higher discount factor meaning the business receives less cash upfront for their invoices. It is important to note that factors spend a considerable amount of time and resources examining invoices and working out the likelihood of payment. As such the factors offered on invoices tend to reflect the degree to which they believe the invoices will be paid on time.
Factoring services are an important aspect of big and small business. By engaging a factor businesses can dedicate their resources to their core business and leave the functions of accounts receivable to those who have specialised resources to handle that function. All in all the more care taken when extending credit to customers the better the discount rate applied will be. However, the effects of the economic state and credit market must not be forgotten when looking at recourse factoring and non-recourse factoring.