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” Factoring. Invoice Factoring costs can vary between 2 – 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 organisation 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 take up the services of
a Factoring Agent. 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 “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 non-paid 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.
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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.
The Factoring Agents act like an insurer 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 a 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 Agents 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 cover provided by the Factoring Agent 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.
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