The biggest question concerning debt
factoring is what happens if a supplier’s customer, who placed the order and
received the goods or services, fails to pay the supplier's invoice. The answer
depends on whether the factoring scheme is defined as "recourse" or
"non-recourse” factoring.
The costs of using non-recourse
factoring are higher due to the increased commercial risks of supplier invoice
non-payment by the supplier's customers. Generally speaking:
- Recourse factoring means that the supplier will have
to pay the value of the invoice to the factoring agent in the case of any
non-payment of invoices by its customers. The factoring agent is
purchasing the right to collect the value of the customer's invoices from
the supplier, but does not purchase the debt, as the liability for the
debt is retained by and remains with the supplier.
- Non-recourse factoring means that the factoring agent
will assume the loss of any invoices not paid by the supplier's customers.
The factoring agent is purchasing the right to collect the value of the
supplier's invoices and the debt. The liability for the non-payment of the
customer's invoices is transferred from the supplier to the factoring
agent. Customer debts would be payable to the factoring agent rather than
the supplier.
The factoring agent will charge more for
the increased commercial risks of taking on the liability for the supplier's
non-payment of invoices. Hence, the factoring agent will want to analyse the
commercial risk of the supplier’s customer base and may not be prepared, in
many cases, to offer a non-recourse factoring agreement to smaller trading
entities or trading entities that have a poor record of collecting debts from
their customer base.
In these cases, the costs of a factoring
agent may not make it worthwhile for a supplier to accept their invoice
factoring services. With recourse factoring, the supplier remains liable for
its customer's debts. The supplier that issued the invoice remains liable to
repay the factoring agent when the supplier's customers fail to pay the
supplier's invoices.
Although many factoring agents will have
slightly different recourse options, the main thrust is that recourse covers
what happens if the supplier's customers do not pay the factoring agent or
supplier. If the supplier's invoices are unpaid, the supplier's customers are
usually called the "account debtors”, which may be due to a customer's
financial problems, a dispute about the order, or fraud.
Recourse factoring will extend the
quasi-loan to the supplier from 45 to 180 days. After that period, the supplier
will usually have to pay any monies back to the factoring agent for any
financial resources gained against the supplier invoices that the supplier's
customers did not pay.
When a supplier invoice is not paid
during the agreed grace period, the factoring agent will proceed to
"recourse", which means they will ask the supplier to repurchase the
invoice from the factoring agent. Suppliers can repurchase the invoice in a
variety of ways:
- The supplier can provide the factoring agent with
another invoice to use as collateral.
- The supplier can deduct the unpaid invoice total from
a "reserve account" that the factoring agent holds.
- The supplier may pay the invoice themselves.
It is important to note that even though
the supplier will remain responsible for collecting the unpaid invoice amounts
from its customer, the factoring agent will usually provide a debt collection
service to assist the supplier in managing unpaid invoices for an additional
charge.
In non-recourse factoring, the factoring
agent may retain liability for any unpaid customer invoice on behalf of the
supplier. This means that the factoring agent, not the supplier, will be
responsible for the contracted debt in the case of non-payment of supplier
invoices by its customers. However, this system must meet stringent conditions.
With non-recourse factoring, the
factoring agent will purchase some or all of the supplier invoices and,
eventually, related debts should the supplier's customers not pay the invoices.
As the owner of any unpaid invoice debts, the factoring agent will find ways to
collect the indebtedness at minimum cost, or they will have to bear the
economic loss "without recourse" or charge back the unpaid invoice to
the supplier.
Practically, the factoring agents act
like insurers for the supplier's invoices. In theory, a non-recourse factoring
agreement means that if the supplier's customers fail to pay the invoices, the
factoring agent will take the loss on that invoice, not the supplier.
As with any business
"insurance", suppliers should carefully read the fine print of a
factoring agent agreement, 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 supplier'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 suppliers’ invoices:
- Supplier invoices offset by any matching debt a
customer owes to the supplier.
- Invoices sent directly to a customer instead of the
factoring agent.
- Invoices sent after any breach of agreement with the
factoring agent.
- Supplier invoices disputed for specified or
unspecified reasons.
- Supplier invoices claimed by a supplier where the
supplier's actions dealing with the customer have reduced the chances of
debt collection.
Non-recourse factoring has other
disadvantages, but recourse factoring still has key advantages. There are some
cases when non-recourse factoring may be preferred to recourse factoring. The
burden of non-recourse factoring is that the coverage the factoring agent
provides is usually very narrow.
The costs for non-recourse factoring are
high and will be between 40 and 80% more than for a regular recourse factoring
agreement, assuming that the supplier is offered a non-recourse factoring
agreement, as the risk for the factoring agent may be unacceptable. 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 supplier's invoices
for factoring.
- Provide a higher degree of support for the supplier's
business.
- The factoring agent may provide free or reduced-cost
credit checks to assist in analysing the supplier's customer base.
However, it is essential to note that
the supplier must maintain a reserve account for the factoring agent if its
customers default on paying the supplier's invoices. An SME may need more funds
to support such an account.
Suppliers interested in recourse and
non-recourse factoring must be careful to read such agreements and ensure that
they review their financial needs. The solvency of the supplier may depend on
the small print within the factoring agreement proposed by a factoring agent.
Suppliers 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 suppliers.
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