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Where does factoring belong in the family of supplier-led working capital solutions?

Published on 2021-11-16

Corporate credit products can usually be divided into two categories - investment and liquidity loans. A liquidity loan (also called a working capital loan) is a short-term (up to 1 year) facility to manage operational cash flows. Such loans can be used to finance orders and long payment terms before the invoice is settled. Banks offer a variety of working capital loans: overdraft, revolving credit line, bridge loan, factoring, invoice-based loans, etc.

Invoice finance has become popular among working capital loan products as the funding solution corresponds exactly with the funding need (invoice period and amount). In a growing number of cases, interest fees are applied only for the financing period, while annual or contract fees are not charged.

Financiers are interested in this type of financing due to enhanced risk management - knowing why, when and what is being financed offers greater security than blank working capital facilities and are easier to organize than loans with collateral.

Moreover, the invoice can serve as the collateral, so there is no need for a “firm pledge” (when property is pledged to the lender in accordance).

When it comes to supplier-led financing solutions, three main instruments should be mentioned: factoring, invoice discounting and receivables discounting.

In factoring, the step order is as follows:

  • A supplier sells its unpaid sales invoices to a financier (usually a bank or factoring company);
  • A financier makes a partial advance payment to a supplier immediately (usually 80-90% of the invoice amount);
  • final payment (remaining 10-20% minus the discount fee) is made when the buyer settles.

The financier typically takes responsibility for collections, which mitigates risks for the financier and makes the entire process more efficient. The buyer is expected to validate invoices to the financier for risk mitigation, but such confirmations are legally unbinding.

Factoring is often compared to another type of working capital loan - overdraft. Unlike overdraft, however, factoring providers should not require any collateral and can finance in greater amounts due sharing risk with stronger buyers.

In the receivables discounting solution, the supplier sells the unpaid invoice to the financier, who finances the full amount (less the discount fee). The rights and obligations are assigned to the financier, which means that the financier assumes full credit risk as well as responsibility for collections. In most instances, there is no recourse to the supplier should the payment default.

Receivables discounting is intended for suppliers whose customers have a stronger credit profile than themselves and typically take on binding payment obligations.

In the invoice discounting solution, the supplier requests an advanced payment for an unpaid invoice. The financier makes a partial or full payment to the supplier for the invoice, and expects repayment on the expected settlement date. Unlike factoring and receivables discounting, responsibility for collections falls on the supplier.

The main advantage of invoice discounting is that the buyer is not involved in the process, which in turn means that the financier can not take the buyer’s risk profile into account.

Each tool has its advantages. In case of factoring, it does not require any collateral and provides financing for greater amounts - this is valuable for suppliers who have buyers with strong credit profiles. Invoice discounting, however, will be a right solution if the buyer has weak credit capabilities and wants to remain passive in the process. Finally, receivables discounting will be suitable in case the buyer’s credit profile is strong and the bank is ready to give up recourse to the supplier.

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