Change of creditor: when factoring is the solution

Feature | 14 January 2016

Factoring is a staple of open account trade and is a popular solution for sellers facing working capital problems. Peter Brinsley explains how it works

Factoring is a receivables finance technique where trade is on open account terms and there is no negotiable payment instrument associated with the transaction. The tenor of the transaction is typically no more than 90 days from invoice date.

Open account trade is attractive to buyers because payment is made up to three months after the goods or services are received. The seller may see it as high risk because there is no instrument guaranteeing the payment obligation. The seller may also find his own suppliers need paying before his receivable is paid by the buyers, hence a classic cash flow gap.1

Addressing the cash flow gap

Factoring can bridge that gap. The financier advances funds to the seller when sales invoices are raised. The amount advanced is directly related to the value of the invoice and therefore the amount of finance available through factoring reflects the growth of the revenues of the seller. More invoices raised means more finance available.

In factoring, the financier takes ownership of the receivable with the transfer of ownership done through the seller assigning the receivable to the factor. The factor wants ownership of the receivable because repayment of any finance advanced comes from the buyers, the entities who owe the receivable as represented by the sales invoices. Following assignment of that receivable the debt is owed to the factor rather than to the seller. The factor is therefore interested in the ability and willingness of the buyer to make payment.

Factoring offers at least two of the following services:

  • finance to the supplier;

  • maintenance of accounts relating to the receivables;

  • collection of payment from the buyer; and

  • protection against default in payment by the buyer.

Product variations

The umbrella term 'factoring' covers many products, each one offering variations on the above list.

In non-recourse factoring, the factor provides all four of the above services including taking the risk of the buyer not making payment.

By contrast, recourse factoring is where the risk of the buyer not paying is borne by the seller. When one of the services is the factor collecting payment from the buyer, the face of the invoice will state that it's been assigned to 'ABC Factor' and to clear the debt the buyer must make payment to them, and the factor's bank details are shown.

Another variant is confidential invoice discounting where only the first two services on the list of four are provided. It's confidential because there's no notice of assignment on the invoice and therefore the buyer does not know that his supplier has factoring. Also, collections are handled by the seller who holds buyer payments in trust for the factor or in some jurisdictions payment goes to a bank account controlled by the factor but in the name of the seller, thus maintaining confidentiality.


Where finance is one of the services being offered - the seller almost always wants to improve cash flow - an advance payment by the factor to the seller of around 80% to 90% of the face value of the sales invoice is made as soon as it is raised and assigned to the factor.

After the initial advance the balance of the invoice value is paid to the seller when the buyer makes payment on or after the invoice maturity date. At this stage a fee for the factor's services is charged to the seller.

Laws and regulations differ around the world, and there may be specific local requirements if you want to operate as a factor. Often a banking licence is needed to do factoring; in some countries non-banking financial institutions (NBFIs) are also eligible. A financier's decision to set up a factoring operation should also consider the following questions:

  • Is there a specific law on transfer of receivables in your legal environment? You want the comfort of knowing that the local legal system - both legislation and the courts - defines transfer of receivables, understands factoring, and will support your claim over the receivables and the right to receive payment.

  • What third-party rights may affect assigned receivables? Can other parties who hold security over assets of the seller challenge your claim over the receivable?

  • Is ban on assignment valid? Do such clauses prevent transfer of ownership of the receivable?

  • What is the position of the financier in the case of insolvency of the seller? You'll want clarity over your rights to the receivable particularly when an insolvency practitioner has been appointed.

  • Is there a central registry of interests over the receivable? To guard against double assignment of the receivable to different financiers.

In some countries, these issues may not have been clarified. It doesn't mean to say you cannot practise factoring but the risks will be challenging and possibly unacceptable to shareholders and backers.

Whole turnover

In most markets factoring is 'whole turnover', which is where the seller assigns all its current and future sales invoices. The attraction to the factor is that his risk (i.e. the risk of not getting his money back through buyer payments) is not concentrated in one buyer or a small group of them. However, single invoice factoring has developed, and with this type of factoring, there is no spread of risk.

The factor might mitigate the risk by verifying every receivable with the buyer and obtaining written acknowledgement that the goods or services have been delivered or performed correctly, and that payment will be made.

Quality of receivable and buyer

It is vital that the factor understands the ability and willingness of the buyer to make payment. Why? Because this is how factoring is repaid.

The factor must also fully understand the receivable and any impairments to its quality which reduce its value, otherwise known as dilution. Examples include sale-or-return, settlement discounts, reciprocal trading, retentions and post-sale contractual obligations.

Impairment issues will come from close examination of documentation and processes around the sales contract, purchase order, order acknowledgement, invoice and proof-of-delivery. A factor should also form a view on concentration of receivables.

Here are the questions they need to ask:

  • Are there only a few buyers?

  • Should the risk be spread more widely?

As part of assessing the quality of buyers, a factor will determine the legal status of the buyers (limited company, partnership or sole trader), obtain credit agency reports, analyse the buyer's financial accounts and understand the buyer-seller trading relationship.

In some countries credit and financial information on businesses varies in quality or is unreliable. It may simply not be available to begin with. In such circumstances, direct contact with buyers may be the best or the only way to begin your assessment.

The factor may seek to mitigate risk by taking out credit insurance on the buyer, if it is available, but you nevertheless still need to understand the quality of the receivable.

Fee structure

There are two standard fees in factoring:

  • a service fee; and

  • a discount fee.

A service fee is a percentage of the value of the receivable, and a discount fee expressed as a percentage over base rate and applied daily to the balance of the finance advanced to the seller. The discount fee is the same irrespective of the factoring product and, like an overdraft, is expressed as x% over base.

Service fee

The service fee covers the costs of the factor for the type of factoring being offered, plus a margin. For example in non-recourse factoring the service fee will reflect the workload required as a direct result of the number of buyers, the number of new buyers added each month, and the number of invoices and credit notes raised on average in the year.

The service fee in confidential invoice discounting is lower than in 'full service' factoring because the above criteria is largely irrelevant since there is no detailed, invoice-by-invoice record of the buyer accounts kept by the factor, and collections are done by the seller.

Receivables purchase agreement

Any type of factoring facility should be based on a receivables purchase agreement (RPA) between the factor and the seller. This stipulates that the seller agrees to transfer all rights in relation to present and/or future receivables to the factor, and the factor accepts those rights without necessarily obtaining the consent of the buyer.

Depending on local laws and accounting rules, when the transfer of ownership of the receivable in factoring is a true sale, the seller may be able to remove the receivable from the balance sheet and show the advance from the factor as cash. Since it is not a loan there is no liability. The attraction for the seller of this off-balance-sheet finance is an improvement in liquidity while avoiding additional leverage. An RPA typically includes:

  • maximum buyer concentration percentage: this limits the factor's exposure to any one receivable to x% of the gross receivable;

  • excluded receivables - e.g. inter-company receivable, and cash sales;

  • advance percentage;

dilution and performance covenants - e.g. the factor might reserve the right to reduce the advance percentage if credit notes exceed, say, 3% of receivables (by value) or days sales outstanding exceeds the yearly average; and

  • Recourse period is typically 90 days.

Peter Brinsley is the managing director of Point Forward consultancy firm in the UK. This article was published in association with IFS University College as part of the TFR Fundamentals series.

"The factor wants ownership of the receivable because repayment of any finance advanced comes from the buyer"



  1. See also Peter Brinsley's article on factoring in sub-Saharan Africa at


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