Factoring with Recourse

Factoring with recourse is a form of invoice finance in which a business sells its unpaid accounts receivable to a finance company (the factor) for immediate cash, but remains liable if a customer does not pay. When an invoice goes unpaid beyond an agreed period, the seller must repay the advance, buy the invoice back or swap in a fresh one. It is the most common type of factoring and is used mainly by small and medium-sized enterprises that need working capital faster than their customers pay.

Its counterpart is factoring without recourse, where the factor absorbs the loss if a customer becomes insolvent. Because the seller keeps the credit risk, recourse factoring is cheaper and easier to obtain, and it often works more like a secured loan than an outright sale. Factoring is governed by contract and general commercial law rather than a single rulebook.

Imagine selling a stack of IOUs from your customers to a friend who pays you most of the face value today. Your friend collects from the customers later. The catch is that if one customer never pays, you have to give your friend that money back. You get cash early, but you still carry the worry about who might not pay.

That promise to cover bad payers is what "recourse" means. Because the friend can always come back to you, they charge less and ask fewer questions about your customers. What you are really buying is speed: instead of waiting a month or two for payment, you can pay wages and suppliers now. The arrangement only makes sense if you trust your customers to pay in the end.

The seller and factor sign a factoring agreement, usually a receivables purchase agreement, and the seller then assigns invoices as it issues them. A typical cycle runs as follows:

1. The seller delivers goods or services and sends a commercial invoice to its customer (the debtor), with instructions to pay the factor.
2. The factor checks the invoice and advances a share of its value, commonly 70 to 90 percent, keeping the rest as a reserve.
3. The factor collects payment from the debtor, often running the seller's sales ledger and credit control as part of the service.
4. When the debtor pays, the factor releases the reserve minus its charges.
5. If the debtor has not paid by the end of the recourse period (often 60 to 120 days after the due date), the invoice is handed back and the seller refunds the advance.

Arrangements can be notified, where debtors are told to pay the factor, or confidential (invoice discounting), where the seller keeps collecting in its own name and the factor stays in the background.

Charges usually have two parts: a discount charge, which is interest on the money advanced for the days it is outstanding, and a service fee for collection and ledger management, set as a percentage of invoice value. The seller's net cash from one invoice is:

• $F$ is the face value of the invoice.
• $A$ is the advance rate, as a decimal.
• $r$ is the annual discount rate charged on the advance.
• $d$ is the number of days until the debtor pays.
• $s$ is the service fee, as a decimal of face value.

Take a 100,000 invoice, an 85 percent advance, a 10 percent annual rate, payment after 45 days and a 1 percent service fee. The advance is 85,000. The discount charge is 85,000 × 0.10 × 45/365, about 1,048. The service fee is 1,000. Net proceeds are about 97,952, of which 85,000 arrives on day one and the remainder when the debtor pays. If the debtor never pays, the seller owes the 85,000 back plus charges.

Because the seller keeps the default risk, recourse factoring often fails the tests for removing receivables from the balance sheet. Under IFRS 9, an entity derecognises a financial asset only when it transfers substantially all the risks and rewards of ownership (or gives up control), so recourse deals are typically shown as a borrowing secured on the receivables. US GAAP applies its own transfer rules in ASC 860, which focus on legal isolation and control. Lenders and analysts therefore often treat recourse factoring like other short-term debt.

Legally, the factor still takes an assignment of the receivables and registers its interest where local law requires, for example a UCC-1 financing statement in the United States. This gives it priority over other creditors holding collateral claims, and it can conflict with a bank's general security, so factors often ask for a waiver from existing lenders.

Recourse factoring suits firms with a reliable customer base but long payment terms, such as staffing agencies, wholesalers, freight carriers and manufacturers selling to large retailers. It is often cheaper than unsecured lending because the factor looks mainly at the quality of the debtors rather than the seller's own credit history. Factors still run know-your-customer checks and verify invoices to guard against fake or duplicated invoices.

The main drawbacks are the retained risk and cost. A large customer failure lands back on the seller at the worst moment, so some sellers combine recourse factoring with trade credit insurance. Fees can also be high relative to a bank revolving credit facility, and customers may read a notified arrangement as a sign of financial strain. Sellers that work with large, highly rated buyers may find reverse factoring cheaper, since pricing then rests on the buyer's credit. Firms track the benefit through lower days sales outstanding and a shorter cash conversion cycle.

• FCI (global factoring association)
• IFRS Foundation