Factoring

What is factoring?

Factoring denotes the ongoing sale of trade receivables, that is, of outstanding invoices to customers, to a specialised financing company, the factor. In German it is also called Forderungsverkauf or Forderungsfinanzierung. The factor pays out the greater part of the invoice amount immediately, collects the receivables from the customer and, in true factoring, additionally takes on the risk that the customer becomes insolvent. The company thus exchanges an invoice that would be paid only in a few weeks for money today, less the factor's costs.

Legally, factoring rests on a framework agreement. In it, the company undertakes to offer its receivables on an ongoing basis or to an agreed extent. Each individual receivable is then sold and assigned, that is, transferred, to the factor under Section 398 of the German Civil Code (Bürgerliches Gesetzbuch, BGB). Providers are factoring companies owned by banks and independent ones; in Germany they require a licence from the Federal Financial Supervisory Authority (BaFin). The instrument serves to finance working capital, the capital tied up in day-to-day business mainly in receivables and inventories. It is used predominantly for receivables against business customers (B2B factoring), less often for receivables against consumers, which are purchased mainly in online retail via payment service providers.

Functions and process of factoring

Factoring combines three functions, which are agreed individually or together depending on the contract:

• Financing: the factor advances the receivable, often at 80 to 90% of the gross invoice amount. The rest remains as a security retention for cash discounts, credit notes and complaints and is settled after the customer pays.
• Credit protection (del credere): in true factoring, the factor assumes the default risk within the limits it sets per customer.
• Service: the factor takes over credit checks, accounts receivable accounting, dunning and collection of the receivables.

In the process, the company transmits each invoice to the factor, which checks it against the customer's limit and usually pays out the advance within a few days. Variants are in-house factoring, in which the company keeps accounting and dunning itself, and maturity factoring, in which it forgoes the advance and uses only credit protection and service.

True and recourse factoring

In true factoring, the factor buys the receivable definitively and bears the del credere risk, that is, the risk that the customer does not pay because of insolvency. Legally this is a purchase of a receivable (purchase of a right under Section 453 BGB): the company is liable only for the receivable existing and being free of objections (liability for existence, Veritätshaftung). If the customer disputes the receivable, for example because of a defect, the factor charges it back. The factor is paid for assuming the default risk through a del credere premium or a higher fee rate; receivables above the customer limit it buys without del credere protection or not at all.

In recourse factoring (unechtes Factoring), the factor can charge back the receivable if payment defaults. The default risk stays with the company; according to case law, it is a credit transaction in which the receivable is assigned only to repay the advance. Which variant applies results from the contract and not from its designation.

Before concluding the contract, it must be clarified whether the receivables have already been assigned in advance. This happens, for example, through a blanket assignment (Globalzession) to the company's house bank, that is, the assignment of all customer receivables as collateral for credit. A second case is the extended retention of title of a supplier, who has the receivables from the resale of its goods assigned to it. Factor and bank then often conclude a delimitation agreement. Against an extended retention of title, according to case law, as a rule only true factoring prevails, because the factor pays for the receivable definitively like a buyer. Case law treats recourse factoring in this situation like a bank loan, so that the supplier as a rule keeps priority.

Disclosed and undisclosed factoring

In the disclosed procedure, the assignment is notified to the customer. The invoice bears an assignment notice, and after notification the customer can in principle pay with discharging effect only to the factor. In the undisclosed procedure, the customer learns nothing of the assignment and continues to pay the company, which passes the amounts on to the factor. This requires good creditworthiness and reliable processes; factors reserve the right to disclose the assignment in the event of irregularities. Whether customers accept an assignment notice without queries depends on the industry and customer structure. The choice of procedure therefore also affects the customer relationship.

Costs, accounting and liquidity effect of factoring

The costs consist of the factoring fee on the revenue purchased, the interest on the advance drawn for the actual term and, in true factoring, the del credere premium. In addition there are often checking fees for new customers, minimum turnover or minimum charges. Offers become comparable only when all items are added up for one year and related to the liquidity provided.

Formula: cost rate in % = annual costs (fee, interest, del credere premium, ancillary costs) divided by average receivables advanced × 100

Under the German Commercial Code (Handelsgesetzbuch, HGB), in true factoring the receivable is derecognised on sale, because the default risk passes to the factor. Cash and a receivable from the factor in the amount of the retention take its place. If the funds are used to repay liabilities, total assets fall and the equity ratio rises. In recourse factoring, the receivable stays on the balance sheet and the advance appears as a liability. Companies reporting under the international standards IFRS apply their own derecognition criteria under IFRS 9; there, retained risks such as the risk of late payment must also be assessed.

For liquidity, factoring shortens the time between performance and receipt of payment to a few days. This reduces the cash conversion cycle, the span between paying own expenditure and receiving money from the customer. In operating cash flow, the introduction of factoring shows up as a one-off inflow, because the stock of receivables falls. Because the financing framework grows with the stock of receivables, it suits companies whose revenue grows faster than their credit lines.

Factoring in due diligence and company purchase

In a funding round, investors ask what share of liquidity factoring provides and how dependent the company is on the factor. They examine notice periods, termination rights on a change of control or deterioration of the financial position, exclusivity and the obligation to offer receivables. In due diligence, the review of the company before contract signing, a usage that rises towards the balance sheet dates stands out. It makes the stock of receivables and net financial debt at the reference date appear lower.

In a company purchase, buyers often treat factoring drawn like a financial liability or add the receivables sold back to working capital. Both routes pursue the same goal: the purchase price should not depend on whether the seller sold its receivables shortly before the reference date. The treatment is set in the definition of financial liabilities or in the mechanism of the working capital adjustment.

Worked example: calculating costs and balance sheet effect of factoring

A company sells receivables of EUR 12 million a year to a factor. Customers pay after 60 days on average. True factoring with a 90% advance is agreed. The factoring fee is 0.8% and the del credere premium 0.3% of the revenue purchased, plus 6% interest per year on the advance. All values are assumed; the calculation is simplified with 360 days.

• Average stock of receivables: EUR 12 million × 60 / 360 = EUR 2.0 million
• Average advanced: 90% of EUR 2.0 million = EUR 1.8 million; retention EUR 0.2 million
• Factoring fee: 0.8% of EUR 12 million = EUR 96,000
• Del credere premium: 0.3% of EUR 12 million = EUR 36,000
• Interest: 6% of EUR 1.8 million = EUR 108,000
• Total costs: 96,000 + 36,000 + 108,000 = EUR 240,000, that is, 2.0% of revenue
• Related to the liquidity provided: EUR 240,000 divided by EUR 1.8 million = around 13.3% per year
• After deducting the costs that fall away for credit insurance and dunning, assumed at EUR 50,000: EUR 190,000 or around 10.6% per year

On the balance sheet, receivables of EUR 2.0 million fall away, EUR 1.8 million of cash and a EUR 0.2 million receivable from the factor are added. The running costs are not taken into account here. If the company uses the EUR 1.8 million to repay an overdraft facility, total assets of EUR 10.0 million fall to EUR 8.2 million. With equity of EUR 2.5 million, the equity ratio rises from 25% to around 30.5%. The cost rate of over 10% per year also shows that factoring is economical above all when the funds released finance growth with a sufficient contribution margin.

Distinctions: factoring, forfaiting and blanket assignment

• B2B factoring: the application to receivables against companies and public-sector customers, with its own questions on assignment bans in customer contracts and on limits for large customers.
• Forfaiting: purchase of individual, often medium- to long-term receivables without recourse, classically from export transactions, without a framework agreement and without a service function.
• Blanket assignment (Globalzession): assignment of all present and future receivables as collateral for a bank loan. The receivables stay on the balance sheet, and customers continue to pay the company.
• Trade credit insurance: covers the default risk for a premium but provides no liquidity.

Common mistakes

• Comparing only the fee. Interest, del credere premium, checking fees and minimum charges make up a considerable part of the costs and become visible only in the annual calculation.
• True factoring assumed, recourse factoring agreed. If the contract contains a right of charge-back on payment default, the risk stays with the company and the receivable stays on the balance sheet.
• Contractual commitment underestimated. An obligation to offer all receivables, minimum terms and notice periods often tie the company for longer than planned.
• Prior assignments not clarified. If the factoring contract collides with a blanket assignment to the bank or an extended retention of title, the factor's acquisition is at risk.
• Factoring as the answer to losses. It shortens the time to receipt of payment but improves neither margin nor earnings.
• Reference date effects created. A conspicuously high usage at balance sheet dates raises doubts in due diligence about the reliability of the figures.

Frequently asked questions

What does factoring cost?

That depends on revenue, customer creditworthiness, invoice size and scope of service. Only the cost rate is meaningful, that is, all annual costs related to the liquidity actually provided.

What are the advantages and disadvantages of factoring?

Advantages are immediate liquidity, a financing framework that grows with revenue, in true factoring protection against bad debts and relief of accounts receivable accounting and dunning. Disadvantages are the costs, the tie to the factor through the obligation to offer receivables and minimum term and, in the disclosed procedure, the assignment notice towards customers.

Is factoring a loan?

True factoring is legally not a loan, because the factor buys the receivable and bears the default risk. Case law, by contrast, classifies recourse factoring as a credit transaction with assignment of the receivable. Economically both forms act like financing, which is why banks, investors and buyers include even true factoring in their analysis of debt.

Do customers learn about factoring?

In the disclosed procedure yes, because the invoice bears an assignment notice and payment is made to the factor. In the undisclosed procedure no, as long as the factor does not disclose the assignment.

Which companies come into question for factoring?

Above all companies with business customers, clearly delimited services and a certain minimum revenue. Difficult are highly concentrated customer structures, frequent complaints and receivables for services not yet rendered.

The Roemer Capital view

In our work as a fractional CFO, factoring usually appears in the liquidity planning of growing companies, when revenue growth ties up funds in receivables before the next funding round is completed. We then compare the annual costs in euros with the alternatives, such as a working capital line or shorter payment terms in sales. This includes the question of whether cash discounts from suppliers, which the company can use thanks to earlier receipts, offset part of the costs.

Before a company sale, we make sure that the use of factoring over the year is documented traceably and treated consistently in the purchase price bridge. We explain fluctuations in usage at reference dates in the data room before a buyer asks about them.