The biggest question concerning debt
factoring is what happens if an organisation’s customer, who placed the order
and received the goods or services, fails to pay the organisation’s
invoice.
The answer depends on whether the
factoring scheme is defined as “Recourse” or “Non-recourse.” Invoice Factoring
costs can vary between 2% and 5% of the value of the invoices concerned,
depending on the levels of risk involved for the Factoring Agent. Non-recourse
Factoring costs are much higher than Recourse Factoring due to the increased
commercial risks of an organisation's invoice non-payment by customers.
Recourse Factoring means that the
organisation will have to pay the value of the invoice to the Factoring Agent
in the case of any non-payment of the organisation’s invoices by the
organisation’s customers. The Factoring Agent purchases the right to collect
the value of the customer’s invoices from the organisation, but does not
purchase the debt as the organisation retains the debt liability.
Non-recourse Factoring means that the
Factoring Agent will assume the loss of any invoices not paid by the
organisation’s customer. The Factoring Agent is purchasing the right to collect
the value of the customer’s invoices and the debt from the organisation. The
liability for the non-payment of the customer’s invoices transfers from the
organisation to the Factoring Agent. The customer’s obligations would be
payable to the Factoring Agent rather than the organisation.
The Factoring Agent will charge
substantially more for the increased commercial risks of taking on the
liability for the non-payment of invoices from the organisation. Hence, the
Factoring Agent will want to analyse the commercial risk of the organisation’s
customer base and may need to prepare in many cases to offer a Non-recourse
Factoring agreement to smaller trading entities or trading entities with a poor
record of collecting debts from their customer base.
Ultimately, the costs of a Factoring
Agent in these cases may not make it worthwhile for an organisation to use
their services. Within Recourse Factoring, the organisation remains liable
for its customer debts. The result is that the organisation that issued the
invoice and called in a Factoring Agent to cover the payment of invoices
remains liable to repay the Factoring Agent when its customers fail to pay
their invoices.
Although many Factoring Agents will have
a slightly different recourse of action, the main thrust is that recourse
covers what happens if the organisation's customers do not pay the Factoring
Agent or organisation. The organisation’s customers are usually called the
"account debtor" for whatever reason that caused the non-payment of
the organisation’s invoices, possibly due to a customer’s financial problems, a
dispute about the order, or fraud.
Recourse factoring will extend the
customer invoice quasi-loan period to the organisation for 45 to 180 days.
After that period, the organisation will usually have to pay any monies back to
the Factoring Agent for any financial resources gained against the
organisation's invoices not paid by the organisation's customers.
When an organisation’s invoice is not
paid during the agreed grace period, the Factoring Agent will proceed to
“recourse”, which means they will ask the organisation to repurchase that
invoice from the Factoring Agent. Organisations can repurchase the invoice in a
variety of ways:
- Another invoice could be used as collateral.
- The unpaid invoice could be deducted from a Factoring Agent's
“reserve account”.
- The organisation may pay the unpaid invoice itself.
It is important to note that even though
the organisation will remain responsible for collecting the unpaid invoice
amounts from its customers, the Factoring Agent will usually provide a
debt-collection service to assist the organisation in managing unpaid invoices
for an additional charge.
In Non-Recourse Factoring, the Factoring
Agent may retain the liability for any unpaid customer invoice on behalf of the
organisation. Non-Recourse Factoring means that the Factoring Agent, not the
organisation, will be responsible for the contracted debt in the case of
non-payment of an organisation’s invoices by its customers. However, there are
stringent conditions for this system to work.
With Non-Recourse Factoring, the
Factoring Agent will purchase some or all of the organisation's invoices and,
eventually, related debts should the organisation’s invoices have yet to be
paid by the organisation's customers. As the owner of any unpaid invoice debts,
the Factoring Agent will find ways to collect the indebtedness at a minimum
cost, but may have to bear the financial loss "without recourse" or
chargeback of the unpaid invoice to the organisation.
Factoring agents act as insurers for the
organisation's invoices. In theory, a non-recourse factoring agreement means
that if the organisation's customers fail to pay the organisation’s invoices,
the factoring agent, not the organisation, will take the loss on that invoice.
As with any business
"insurance", organisations should read the fine print of a Factoring
Agent Agreement very carefully, especially about what sources of payment
default are covered, as the non-recourse provisions are usually very narrowly
defined.
Most Non-recourse Factoring Agreements
will only work when the organisation’s customers file for bankruptcy or become
insolvent after issuing the invoice. Typical exclusions for a Factoring Agent's
Non-recourse Factoring Agreement will usually explicitly exclude the following
default reasons for the non-payment of the organisation's invoices:
- Invoices are offset by any matching debt a customer
owes to the organisation.
- The organisation sends Invoices directly to a customer
instead of the Factoring Agent.
- Invoices sent after a breach of agreement with the
Factoring Agent.
- Invoices that are disputed for specified or
unspecified reasons.
- Invoices claimed by an organisation where the
organisation’s actions dealing with the customer have reduced the chances
of debt collection.
The disadvantage of non-recourse
factoring is that the coverage the factoring agent provides is usually very
narrow, and the costs are high. Organisations should expect to pay Factoring
costs between 40 and 80% more than for a regular Recourse Factoring Agreement.
That's assuming that the organisation is offered a Non-recourse Factoring
agreement, as the risk for the Factoring Agent may be at unacceptable levels.
Considering the higher costs of Non-recourse Factoring, Recourse Factoring has
its advantages, such as:
- The Factoring Agent will offer lower rates.
- Approve an increased amount of the organisation's
invoices for Factoring.
- Provide a higher degree of Support for the
organisation's business.
- The Factoring Agent may provide free or reduced-cost
credit checks to assist in analysing the organisation's customer base.
However, it is essential to note that
the organisation must maintain a reserve account for the Factoring Agent if its
customers default on paying the organisation's invoices. An SME may need more
funds to support such an account. Organisations interested in utilising
Recourse and Non-recourse Factoring must carefully read such agreements and
ensure that they review their financial needs.
The organisation’s solvency may depend
on the small print within the Factoring Agreement proposed by a Factoring
Agent. Organisations should be especially wary of sections related to
“recourse”, "credit problem", and "credit event" to ensure
that they know precisely when the Factoring agreement will come into play.
However, even if Recourse Factoring has massive advantages, the costs of using
such services may not be worthwhile for small to medium-sized organisations.
Additional articles can be found
at Commercial
Management Made Easy. This site looks at commercial management
issues to assist organisations and people in increasing the quality,
efficiency, and effectiveness of their products and services to the customers'
delight. ©️ Commercial Management Made Easy. All rights reserved.