A form of financing that is available to organizations is factoring. Factoring arrangements are the sale of or collateralization of current assets to a lender (the factor). The sale of current assets is a true legal sale in which the assets transfer to the factor. The collateralization is actually asset based lending under which current assets are pledged to the lender in exchange for a loan.
The benefits of factoring or asset based lending are shown in the graph.
Factoring can quickly become complicated due to the terms and conditions from a legal point of view and the various options available. This case study looks at what factoring or asset based lending is, when it is most suitable and how the most important components function.
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What is Factoring?
Factoring serves as a container for the sale or collateralizing of current assets like accounts receivables or retail inventory for immediate cash. Organizations can use factoring when there is a high seasonality in the cash cycle. For example when cash is trapped in retail inventory in the shopping street but cash is already needed for producing new collections.
A factoring solution is a flexible source of financing for those organizations:
- that are in a growth phase and have not yet access to bank loans for their growth financing needs
- that have to manage the peaks of cash need during their cash cycle and do not wish to exhaust credit lines/bank loans for this purpose
Under factoring commonly various forms of financing can be understood. The main distinction lies in the form of risk transfer of the underlying agreement. If the risk of non-payment by the customer does not transfer to the buyer – a so-called economic sale – then the agreement is actually a form of asset based lending. See the first two transactional graphs on the right. However if the risk does transfer to the buyer – a so-called full legal sale – then the agreement is a true factoring agreement. This is shown in the thirds graph.
In both cases liquidity is increased. It can even create a competitive advantage if the organization is able to grant longer payment terms to its customers and at the same time get payment discounts from its suppliers by faster payments.
This article will discuss both variations starting with the asset based lending variation.
Asset Based Lending
The main component of asset based lending is the borrowing base. The borrowing base in asset based lending is the total credit limit that can be borrowed. It fluctuates with the underlying collateral.
In this example we will look at a combination in which both accounts receivables and inventory are accepted as collateral in the asset based lending agreement.
For accounts receivables a typical buildup of the borrowing base is to take the gross accounts receivables amount and deduct those accounts receivables that have been excluded based on being overdue. Another typical reduction to undertake is to exclude accounts receivables based on their geographic/jurisdictional origination. This is due to (perceived) difficulties in collecting and is meant to reduce risk for the lender. Typically also concentration limits are in place. The lender applies this to get to a more balanced risk portfolio. If an account receivable takes up a relatively high proportion of the entire portfolio then the amount above the concentration limit is excluded. Limits of 20% are typical meaning a single account receivable may not enlist for more than 20% of the total outstanding amount. Variations on this are that X account receivables may have a maximum of Y% of the portfolio.
The amount so obtained is multiplied with the so called advance rate. The advance rate is determined by factors including for example bad debt history and aging profile of the portfolio.
At this point the borrowing base amount for accounts receivables is determined. An analogous calculation is made for inventory. As a last step there is a split between accounts receivables and inventory.
An example of the borrowing base calculation is:
In an asset based lending construction the accounts receivables remain on the balance sheet of the organization. These are just collateralized, no sale has been made.
In an asset based lending construction both recourse or non-recourse can be agreed upon. If the lending is on the basis of recourse the lender has the right to collect the receivables if the borrower fails to meet its debt obligations. If it is agreed on non-recourse terms the lender has no right to collect the receivables. This increases the risk for the lender and results in a higher cost of capital for the borrowing organization.
The regular collecting of receivables is normally undertaken by the borrower unless agreed otherwise.
The difference between factoring and asset based lending is the transfer of risk. Under a factoring agreement the outstanding invoices are transferred to the factor in a full legal sale. The factor obtains the risk for any non-payment by the customer. The organization is under a factoring agreement guaranteed of the cash it gets for the sale of invoices.
For determining which invoices can be sold to the factor the same limitations and terms can be applied as with a borrowing base as explained in the asset based lending example.
The accounts receivables in a factoring agreement are off the balance sheet of the organization as they have transferred to the lender. This shortens the balance sheet and improves the equity ratio of the organization if the proceeds are used to reduce liabilities. A higher equity ratio increases the bank rating as well for bank funding. A full legal sale is in principle a full recourse sale because the lender obtains full legal title to the outstanding items including the right to collect.
Contractually a service agreement can be construed in which it is agreed that the organization undertakes the collection of the receivables for a service fee. This is useful in intercompany factoring solutions where the local subsidiary knows the language and the local customers.
The pricing for asset based lending or factoring agreements historically is higher than for more traditional borrowing agreements like credit lines and bank loans. This explains why asset based lending and factoring is mostly used in growing organizations which do not have the scale and bank credit rating yet to finance upon.
Factors look for their pricing to the risk of the portfolio that they are lending upon. The credit risk is determined based on the accounts receivables and not of the organization itself. This means that an organization that does not have a rating but has a customer base with a very good rating can have relatively good terms in their factoring contract. Terms and conditions of the agreement make up the total price determination.
The lender (factor) wants to ensure that the collateral is sufficiently insured. It is up to the contractual parties to agree upon who is responsible for arranging the agreed level of insurance and who pays for it.
Take into account
Asset based lending is a flexible form of financing which is available alongside bank financing to cover for temporary organic growth financing.
Factoring is often attributed the benefit of increasing creditworthiness of an organization. This holds true in case of real factoring – a true legal sale. But not in the case of asset based lending. After having read through the borrowing base calculations it shall be clear that the best assets are pledged for cash in exchange for a loan. That is not by definition an improvement in the sense of creditworthiness. Since in many cases asset based lending and factoring are used for the same instrument it is paramount to know the terms and conditions to know what the organization is dealing with. If the goal is to increase creditworthiness then a true legal sale should be considered and not an asset based lending construction.
Flexibility of both asset based lending and factoring comes at the cost of higher total cost of capital. Also the associated workload in an organization is typically higher than with bank financing. This is due to the fact that information must be supplied to the lender on the collateral and each of the limiting factors (overdues, aging analyses, geographical splits, warehouse locations and quantities, quality checks etcetera). The organization must be able to cater for the resources to provide the information to the lender on a frequent basis.
The higher cost of capital and relatively higher workload may seem like a burden but the fact is that this form of financing is more easily available and scalable than a bank loan. Factoring can just enable making that one investment or entrance into that new marketspace.
- Increases liquidity
- Has potential to improve bank rating
- Is an alternative to bank financing
- May create competitive advantage by granting longer payment terms to customers and faster paying of suppliers
As always a good plan should exist for financing. Knowing how much financing is needed and for how long is the key to success. A good forecasting process will help in the decision making. Read more in the article on forecasting.
Consider factoring not only externally but also within an international group for intercompany financing. This works very well in combination with an In House Bank setup. Treasury Improvement has experience in asset based lending and factoring in both external and intercompany setups.
Contact Treasury Improvement to explore opportunities for your organization.