Factoring is a financing method in which a business owner sells accounts receivable at a discount to a third-party funding source, in order to raise capital1
. In other words, factoring involves selling unpaid customer invoices to raise capital quickly. It allows business owners that experience slow-paying customers or occasional cash flow squeeze to generate cash flows almost instantly to run their businesses.
My first exposure to factoring was over a decade ago, when we were attempting to raise bank financing for a newly incorporated US subsidiary of a European client. I was astonished to learn that without a few years of operating track record in the US, no corporate guarantee from a prosperous European parent company, nor anything else, could help to persuade US banks to lend. Although the subsidiary had no credit record to speak of, its clients had an excellent record. Hence the receivables could be sold at a relatively minor discount. The cost of factoring was only a few percentage points more than bank financing.
Factoring is one of the oldest forms of business financing; it is common in some industries particularly where long receivables are part of the business cycle.
Factoring is commonly perceived as the most expensive way to raise cash – a last-ditch effort by companies about to go under. While it is true that factoring is typically more expensive than bank financing, this perception deserves qualification since factoring is a short-term solution commonly used to provide companies with necessary cash flows to raise working capital in order to drive business growth.
In a typical factoring arrangement, the company makes a sale or provides a service and generates an invoice. The factor buys the right to collect on that invoice by agreeing to pay (usually within 24 to 48 hours) the invoice’s face value less a discount. The factor usually pays 75 percent to 80 percent of the face value immediately and forwards the remainder (less the discount) when the invoice is fully paid.
Factoring companies apply a discount to the invoice’s face value – a factoring fee that typically range from 1% to 5% of the invoice amount1, depending on several elements:
Exhibit 1: Global factoring volume distribution in 20183
The global factoring market was worth €2 767 Billion in 20184.
The factoring industry has been experiencing a significant increase in emerging markets, particularly Asia and Eastern Europe, where SME and entrepreneurial sectors are growing rapidly. Within the Visegrad countries, the factoring industry is much larger in Poland than other countries and also growing faster.
Exhibit 2: Factoring volume in Visegrad countries for 2012-2018, million EUR5
Factoring is expanding rapidly in Central Europe for two main reasons:
Factoring may also allow SME’s to effectively outsource their credit and collection functions to their factor7. Moreover, invoice factoring is considered as an off-balance sheet financing method, since no debt or equity is created; hence liabilities do not have to be reported.
As mentioned, factoring fees are on average more expensive than conventional lenders; there may also be hidden fees, such as application, servicing or processing fees.
Factoring entails the loss of direct control on invoice collection. Clients may react adversely if they experience collection pressures from a factor. One should ensure the factor chosen is fair and ethical so as not to undermine the company’s reputation or client relationship.
Most factors will also specify that in the event a company’s client does not pay within a predefined time period, the factor will look for recourse to the company.
In summary, given the choice between a bank loan and factoring, most companies will prefer a bank loan. Nevertheless, where a company has limited access to conventional financing, and can generate higher returns on capital than the cost of factoring, factoring remains a desirable option.
My first exposure to factoring was over a decade ago, when we were attempting to raise bank financing for a newly incorporated US subsidiary of a European client. I was astonished to learn that without a few years of operating track record in the US, no corporate guarantee from a prosperous European parent company, nor anything else, could help to persuade US banks to lend. Although the subsidiary had no credit record to speak of, its clients had an excellent record. Hence the receivables could be sold at a relatively minor discount. The cost of factoring was only a few percentage points more than bank financing.
Factoring is one of the oldest forms of business financing; it is common in some industries particularly where long receivables are part of the business cycle.
Factoring is commonly perceived as the most expensive way to raise cash – a last-ditch effort by companies about to go under. While it is true that factoring is typically more expensive than bank financing, this perception deserves qualification since factoring is a short-term solution commonly used to provide companies with necessary cash flows to raise working capital in order to drive business growth.
In a typical factoring arrangement, the company makes a sale or provides a service and generates an invoice. The factor buys the right to collect on that invoice by agreeing to pay (usually within 24 to 48 hours) the invoice’s face value less a discount. The factor usually pays 75 percent to 80 percent of the face value immediately and forwards the remainder (less the discount) when the invoice is fully paid.
Factoring companies apply a discount to the invoice’s face value – a factoring fee that typically range from 1% to 5% of the invoice amount1, depending on several elements:
- The monthly volume of invoices to factor
- The average amount of each invoice
- The industry
- Length of time for payment
- Customers’ creditworthiness
Exhibit 1: Global factoring volume distribution in 20183
The global factoring market was worth €2 767 Billion in 20184.
The factoring industry has been experiencing a significant increase in emerging markets, particularly Asia and Eastern Europe, where SME and entrepreneurial sectors are growing rapidly. Within the Visegrad countries, the factoring industry is much larger in Poland than other countries and also growing faster.
Exhibit 2: Factoring volume in Visegrad countries for 2012-2018, million EUR5
Factoring is expanding rapidly in Central Europe for two main reasons:
- CEE is one of the world’s fastest growing areas with a 4.01% average GDP growth for the 2015-2018 period6.
- Former socialist countries have evolved into market economies over the past three decades. Hence they have experienced intense growth, with great need for capital, and need to tap into every source of capital available.
Factoring may also allow SME’s to effectively outsource their credit and collection functions to their factor7. Moreover, invoice factoring is considered as an off-balance sheet financing method, since no debt or equity is created; hence liabilities do not have to be reported.
As mentioned, factoring fees are on average more expensive than conventional lenders; there may also be hidden fees, such as application, servicing or processing fees.
Factoring entails the loss of direct control on invoice collection. Clients may react adversely if they experience collection pressures from a factor. One should ensure the factor chosen is fair and ethical so as not to undermine the company’s reputation or client relationship.
Most factors will also specify that in the event a company’s client does not pay within a predefined time period, the factor will look for recourse to the company.
In summary, given the choice between a bank loan and factoring, most companies will prefer a bank loan. Nevertheless, where a company has limited access to conventional financing, and can generate higher returns on capital than the cost of factoring, factoring remains a desirable option.
1Factoring by Enterpreneur.com, https://www.entrepreneur.com/encyclopedia/factoring
2ibid
3FCI Annual report – The Global Association for the Open Account Receivables Finance Industry
4ibid
5ibid
6The World Bank Data
7The Role of Factoring for Financing Small and Medium Enterprises by Leora Klapper
2ibid
3FCI Annual report – The Global Association for the Open Account Receivables Finance Industry
4ibid
5ibid
6The World Bank Data
7The Role of Factoring for Financing Small and Medium Enterprises by Leora Klapper