Factoring can be a confusing part of a company’s finances, especially when taking into account the different forms of factoring that exist. We’ll explain to you the difference between two forms of factoring: Non-recourse factoring vs. recourse factoring.
Most companies use factoring without recourse due to a lack of knowledge regarding factoring options. In the following we are going to explain the difference between the two before exploring the idea behind factoring without recourse which is the most common way of factoring.
What is Factoring?
Factoring is used to improve cash flow and to access cash tied up in invoices faster.
Firms often struggle with payment terms of 30 or more days. They provide products and services but do not get paid for another 30 days after issuing an invoice. In this time they often have to pay their own suppliers and employees without having been paid themselves.
Factoring helps with this problem: An issued invoice is bought at a discount by a factoring firm which allows the issuer of the invoice to receive funds at the time of issuance rather than when the invoice is paid by the debtor.
Factoring involves three parties:
- The Issuing Firm has supplied products or services and has issued an invoice for the same
- The Debtor is the issuing firm’s client who received goods and services and is now liable for payment
- The factoring firm offers a factoring agreement to the issuing firm and advances funds to the issuing firm in advance of the invoice payment.
The issuing firm and the factoring firm usually sign a contract laying out the procedures and terms of the factoring agreement about which the debtor is then informed.
In factoring agreements, the factoring firm takes control of the issuing firm’s entire sales ledger, so all invoices are factored. This limits the issuing firm’s control over their invoices but also ensures that they always receive finance immediately whenever they issue an invoice.
The difference between the two factoring methods is what happens in case of default on the invoice.
In a non-recourse factoring agreement the loss of unpaid invoices is absorbed by the factoring firm so the invoice issuer is not affected by non-payments.
In case of recourse factoring, the invoice issuer must return all funds received from the factoring firm when an invoice remains unpaid. Thus, the risk of default remains with the invoice issuer rather than with the factoring firm in a recourse factoring agreement.
It is important to be aware of who assumes the risk in case of default before signing any factoring agreement. Find out more about the difference between the two here.
Advantages of Non-recourse Factoring
- Earlier payment of invoices
- Risk of default is fully transferred to a third party
- No need to chase payments or follow up on late payments
- Simplification of accounting as accounts receivables are erased
Even though non-recourse factoring offers many advantages, it is also significantly more expensive and it is very inflexible compared to other cash flow solutions such as invoice finance.