What is factoring?
Factoring occurs when a business (“the Client”) enters into an agreement with another business (“the Factor”) in terms of which the Client sells its book debts to the Factor, generally on an ongoing basis, for a fee plus interest. The benefit is that the Client receives payment immediately and the Factor collects the book debt. The debtors now deal directly with the Factor, regarding payment.
Benefits of factoring
- One of the principal benefits of factoring relates to cash flow. In the ordinary course of business, the Client will usually purchase goods from its suppliers and supply goods to its customers on a credit basis. Factoring enables the Client to receive the bulk of the amounts owed by the customers very shortly after the rendering of an invoice, with the result that suppliers can be paid in cash and cash discounts negotiated. When properly managed, factoring can result in an improved balance sheet structure for the Client.
- Factoring can also protect the Client against the risk of default by debtors, whether fully or partially. This may have the added benefit of reducing the need for credit risk insurance.
- The cost and administrative burden of administering a debtors’ ledger can also be reduced if it is agreed that the Factor will take over these functions. In the case of maturity factoring, where the Client receives payment for the sale of book debts only once the debtors pay the Factor, this will often be the only benefit of the factoring arrangement.
- Factoring can also double as an alternative to loan finance. The advantage of factoring in this context is that a comparatively larger amount can be obtained through factoring when compared with a loan, particularly if the Client has a large debtors’ book. As may be expected, the cost of obtaining finance through factoring is usually higher than the cost of loan finance.
Pre-Conditions to Factoring:
The goods /services must have been delivered / rendered and the customer must have accepted the goods / services with no pending disputes. The company requesting the bridging should be profitable and have a clean credit record.
- The purchase price is usually the value of the invoices representing the book debts, subject to a retention to cater for possible bad debts. This retained amount (usually in the region of 10% to 25% of the invoice value) is paid to the Client once the Factor recovers the book debts from the debtors.
- As consideration, the Client pays to the Factor a percentage of the invoice value of book debts purchased, and/or a percentage of the amounts actually paid to the Client (calculated over the period of time from the date of payment until recovery of the book debts from the debtors). In addition, a fixed monthly or annual charge is sometimes levied (depending on how the factoring agreement is structured).
- Typically, a once-off set-up fee of approximately 3 % to 5 % per value of invoices, depending on the size of the invoice bridging required and a monthly cost of between 4,5 % and 6 %
- Limits are usually set for the total outstanding amount of book debts purchased by the Factor, who will often take over the administration of the Client’s debtors’ ledger, particularly in non-confidential factoring. Factoring houses generally offer distinctive products for export, import and domestic factoring.
Confidential or non-confidential
Factoring can take place on a confidential or non-confidential basis. In confidential factoring, the debtors are not informed that their debts have been factored, with the result that they continue to pay the debts to the Client. This carries significant risks for the Factor and must be carefully dealt with in the factoring agreement. Non-confidential factoring involves notice of the factoring arrangement to the debtors who then pay the debts directly to the Factor.
Recourse and non recourse
In the case of non-recourse factoring, the Factor takes over the risk of non-payment by the debtors, subject to certain conditions, whilst in recourse factoring the Factor may require to be reimbursed by the Client if a debtor fails to pay. Factoring arrangements often involve a combination of recourse and non-recourse factoring.
Factoring agreements usually incorporate a wide range of suretyship, pledge and agency provisions to protect the Factor against bad debts and insolvency of the Client, amongst other potential problems. Due to the novel legal structure and complex nature of factoring arrangements, factoring agreements must be carefully drafted to ensure that the intentions of the parties are given effect in a manner that is legally enforceable.