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Management Options
by Irena Jindrichovska
Executive Summary
• Factoring is often understood by businesses to be invoice discounting. However, it is, in fact, the sale
of receivables, whereas invoice discounting is borrowing, where receivables are used as collateral.
• In recent years, factoring has experienced substantial growth, as it has become an important source of
financing for both small and medium-size enterprises (SMEs), as well as for export corporations.
• Both factoring and invoice discounting are methods that help to speed up the collection of receivables,
and thus increase asset turnover and profit generation for corporate shareholders.
• Both factoring and invoice discounting directly affect the performance of corporations as they impact on
working capital, and affect the performance of asset turnover and profit generation.
Factoring
Factoring is provided by financial institutions, for example banks and individual factoring brokers. It is a
form of asset-based financing, where the factor provides funding based upon the values of a borrower’s
accounts receivable, i.e. corporate debtors. The receivables are purchased by the factor rather than used
as collateral for a loan. This means that the ownership of receivables shifts from the seller to the factor.
Factoring generally includes more than just financing, and it also includes funding and collection (Booth and
Cleary, 2007).
Factoring and invoice discounting in the UK is being used by more than 47,000 companies, with a
total volume of €170,000 billion in 2003 (Bakker et al., 2004). It is a popular method of working capital
management in many countries, and is especially helpful for start-up companies, as well as small and
medium-size corporations, to use their working capital more effectively.
Factoring offers some advantages for the factor over lending, and is likely to become more important in
transitional and developing countries. The funding provided to the customer is explicitly linked to the value of
their underlying assets (working capital), and not to the borrower’s overall creditworthiness. This portfolio of
assets (receivables) is being continuously managed, to ensure that the value of the underlying assets always
exceeds the amount of credit.
Simple Illustration
The factor purchases £100 from its client under a factoring contract. The client company (borrower) receives,
from the factor, 70% of the value of the invoice minus interest and service fees, and minus a factoring
commission of, say, 2%. The client receives the remaining 30% upon receiving the payment from its
customer. The amount of £30 serves as a reserve amount, and is kept by the factor until the invoice is paid.
At the beginning of the transaction, the factor advances £68 and acquires ownership of the whole receivable.
When the invoice is paid in 31 days, the factor sends £30 to the client on day 31. The size of the reserve
depends on the perceived risk of the client. There will be an additional cost, which will be the interest on
the outstanding balance of receivables. The interest can be deducted at the beginning, at the same time as
factoring the commission.
The client company pays a commission fee for the factoring service to the factor, as well as interest for the
period of financing. The factor bears the risk of non-paying customers. The factor buys the receivable at a
discount, which ranges from 0.35% to 4%. The interest for factoring is usually 1.5 to 3 percentage points
above the base rate, reflecting the overall risk of the transaction, as well as current market conditions. The
rates are roughly equivalent to bank overdraft rates, and can occasionally be better.
Case Study
Invoice Discounting
Invoice discounting is another policy used by firms to speed up collection of receivables. Invoice discounting
is an alternative way of drawing money against a company’s receivables, i.e., issued invoices. In this case,
the business retains control over the administration of receivables. It provides a cost-effective way for
profitable businesses to improve their cash flow.
There are two parties to this transaction: the client company and the invoice discounter.
This service is provided by banks and financial institutions to businesses that sell products or services on
credit to other businesses. It is normally available to businesses with a proven track record, and annual
turnover of at least £500,000, and is usually a long-term relationship between the business and the invoice
discounter.
Making It Happen
Factoring services in particular are provided by many companies and therefore it pays to look around for
the best deal. Financial companies usually provide both factoring and invoice discounting services. Factors
are usually linked with bigger banks to provide secure funding. Some examples of providers of commercial
finance and asset financing are provided in the next section.
More Info
Books:
• Bakker, M., L. Klapper, and G. Udell. Financing Small and Medium-size Enterprises with Factoring:
Global Growth and Its Potential in Eastern Europe. Washington, DC: World Bank, 2004.
• Booth, L., and W. S. Cleary. Introduction to Corporate Finance. Toronto, ON: Wiley, 2007.
• Klapper, L. The Role of Factoring for Financing Small and Medium Enterprises. Washington, DC:
World Bank, 2005.
• Meckin, D. Naked Finance: Business and Finance Pure and Simple. London: Nicolas Brealey
Publishing, 2007.
Article:
• Soufani, K. “Factoring as a financing option: Evidence from the UK.” Working paper, Concordia
University, 2003.
Websites:
• Factoring Solutions, independent factoring firm: www.factoringsolutions.co.uk
• HSBC, information on factoring: www.hsbc.co.uk/1/2/business/finance-borrowing/invoice-finance
• Independent Factoring Brokers Association: www.factoring-broker.org.uk
• Lloyds TSB, information on factoring: www.ltsbcf.co.uk/factoring
• Royal Bank of Scotland, information on factoring: www.decision-finance.co.uk/
royal_bank_of_scotland_factoring.html
• UK government-sponsored advice agency, Business Link: www.businesslink.gov.uk
See Also
Best Practice
• Best-Practice Working Capital Management: Techniques for Optimizing Inventories, Receivables, and
Payables
• Corporate Finance for SMEs
• Using Securitization as a Corporate Funding Tool
Checklists
• Hedging Foreign Exchange Risk—Case Studies and Strategies
• How to Use Receivables as Collateral