Factoring

Last Updated: Jun 7, 2019

Created By :

Last Edited By :

Created On :

Factoring is the process by which a factor buys the receivables of a client, at a discount. 

The receivables are due from the client’s customers, referred to as the “account debtors.”

There are many variations on the services offered by a factor which are described below and elsewhere in this glossary.

History of Factoring

Some form of factoring can be traced back to the codes of law of ancient cultures – including the Mesopotians, who followed the code of the King of Babylon, named Hammurabi.  He is more famous for coining the phrase “an eye for an eye”, but he also passed laws that enabled trade to flourish.  The ancestors of modern day factors were agents who took possession of goods that still belonged to a manufacturer, and delivered them to overseas buyers.  They usually found the buyers and did the marketing too. Once the goods were paid for they would remit the money, less commission to the original manufacturer. 

In the 14th and 15th centuries, there was a huge expansion in international trade around the Mediterranean, and between Europe and Asia. A rudimentary form of factoring became popular, and helped trade grow.

Then came the industrial revolution. The British textile industry was booming, and the export business was huge. 

Factors made it their business to find out which buyers of textiles could be relied upon to pay.  They would pay their client - the manufacturer - some of the value of the goods upfront, and this payment was in effect a guarantee that the client would be paid in full – minus the factor’s commission.  That worked well for the typical 18th century British mill owner, who needed money for more raw materials, and didn’t want to have to constantly travel overseas to deal with buyers. So factors started doing a roaring trade. 

Although factoring started as a form of trade finance, it became more sophisticated during the boom in the textiles industry in late 19th century in America.   By this time, a lot of trade was domestic, and the manufacturers had their own sales teams.  The big challenge was to get paid for the goods sold and delivered.  Factors took over responsibility for collections, and provided credit while waiting for the customer to pay. 

The factor became an outsourced finance department.  While the client concentrated on manufacture and sales, the factor ran collections and financing, and managed the risk that the customer would not pay.

This the point at which the term factoring expanded to its modern-day meaning, to include all or some of a wide range of financing and credit guarantee services, often packaged with collections and book-keeping.=

One of the benefits of a credit guarantee is it helps a client decide who to accept as a customer.  If the factor is not willing to guarantee the invoice, it is a strong indication they should not be doing business with that customer.

But although funding is now thought of as central to factoring, it wasn’t always part of the package, and some large factors serve clients with the first three services, and not funding. 

Types of Factoring

In Maturity Factoring, the factor still purchases the invoice, but doesn’t pay for it until they have collected from the account debtor.

If the client does want some of the funds in advance, they don’t even have to borrow from the factor.  It may be cheaper to go to the bank and use the amount due from the factor as collateral for a bank loan.

Sometimes people use the term “Traditional Factoring” to describe the collection of services that focus on credit risk, collections and accounting, and that may or may not include finance.

Traditional factoring emerged in the garment and home furnishings industries and is still very common.

Margins are tight in that business, and there is a strong focus on covering credit risk.  The client doesn’t want to lose a year’s profit because a customer didn’t pay. 

The factor is able to guarantee that the account debtor will pay because they are managing invoices from many clients in the same industry that originate from a limited number of large account debtors who are usually retailers.  So they can afford to study these retailers carefully and understand the risks involved.

When a factor purchases an invoice, they guarantee it.  There is no recourse.  They don’t go back to their client for a refund if the account debtor doesn’t pay. That risk is part of what a factor charges for.

So, a traditional factor is serving a client whose primary need is to minimize risk. 

At the other end of the spectrum there are many clients whose primary need is for cash more quickly. 

When a client sells an invoice to a factor, they want the cash in advance of when the account debtor pays.  We call that advance factoring.

In contrast to Traditional Factoring, Advance Factoring usually involves full recourse. In other words, the client retains the risk that the account debtor will not pay. This is because these companies are often selling to a wide range of account debtors, and the cost for the factor to examine the credit worthiness of these debtors is usually prohibitive.  So Advance Factors often ask for a refund if the debtor doesn’t pay, and this is called full recourse.

But remember, these are clients who needed to sell their invoices because they are tight on cash.  They may not even have the cash needed for a refund.  So even a factor who lends on a recourse basis needs to be sure that the account debtor is a good credit risk and is expected to pay the invoice.

A client’s needs can sit anywhere on this spectrum, so you will find many factors putting together a blend of services that combines elements from both ends of the spectrum.