Why Is Factoring Still Such a Blind Spot in Business Finance?

Despite its long history, factoring remains unfamiliar to many accountants, CFOs and financial advisers. We examine the misconceptions, the mechanics and why the product is so frequently overlooked.

One of the more surprising things we’ve learned at TowerCap is how limited the understanding of invoice factoring can be, even among experienced finance professionals.

Accountants, financial advisers and business owners generally recognise the term. Many associate it with distressed businesses, expensive financing or the transfer of customer collections to a third party. Others understand the basic principles but are unfamiliar with the range of arrangements available.

Saul Gewer, Chief Revenue Officer at TowerCap, encounters this regularly.

“We’ll speak to a CFO or financial adviser who’s worked with businesses for twenty years and discover they’ve never actually dealt with a factoring arrangement. Quite often they’re surprised that we can fund receivables without contacting their customers, or that we don’t necessarily need the entire receivables book.”

For a product with such a long commercial history, factoring remains remarkably unfamiliar outside specialist financing circles. Why is that? The mechanics are relatively straightforward, the underlying asset is one every accountant understands, and the working-capital problems it addresses are commonplace. Yet factoring rarely features prominently in routine discussions about business finance.

What actually happens when an invoice is factored?

Factoring involves the sale of accounts receivable to a third party, generally at a discount to their face value.

Consider a company that has completed a contract and issued an approved invoice for $100,000, payable in 60 days. The receivable appears as an asset on its balance sheet, although the company has yet to receive the cash.

A factor agrees to purchase the invoice and advances, say, 80% of its value. The company receives $80,000 immediately. When the customer settles the invoice, the remaining $20,000 is released, less the factoring fee.

If the agreed fee were $2,000, the company would ultimately receive $98,000, of which $80,000 became available well ahead of the customer’s payment date.

The advance rate, applicable fees, eligibility criteria and arrangements for collecting payment vary between providers.

In a genuine receivables purchase, the business transfers its rights to an existing asset rather than pledging that asset as security for a loan.

The difference also affects underwriting. A bank considering an unsecured working-capital loan will assess the company’s financial position, repayment capacity, existing indebtedness and credit history. A factor places substantial emphasis on the quality of the receivables and the ability of the underlying customer to pay.

The seller’s financial condition and operational controls remain relevant, but the creditworthiness of the customer owing the invoice can be particularly important.

There is an accounting qualification. Under US GAAP, ASC 860 requires specified conditions to be met before a transfer of receivables can be recorded as a sale. These include the legal isolation of the assets, the purchaser’s ability to pledge or exchange them, and the absence of continuing effective control by the seller.

Where the conditions are not satisfied, the arrangement must be accounted for as a secured borrowing, regardless of its commercial description.

For a CFO considering factoring, the contractual structure and its accounting treatment both warrant examination.

Why profitable businesses use factoring

Factoring is frequently associated with companies facing financial difficulty, although many funding requirements arise from ordinary operating conditions.

Staffing businesses, for example, may pay employees weekly while invoicing customers on 30- or 60-day terms. Contractors must finance labour, equipment and subcontractors while waiting for approved invoices to be settled. Manufacturers and distributors face similar gaps between supplier payments and customer receipts.

These requirements can become more demanding as revenue grows.

Suppose a contractor generates $2 million in monthly invoices and its customers take an average of 60 days to pay. In steady-state conditions, approximately $4 million may be outstanding in receivables at any time. If monthly revenue increases to $3 million without any change in payment terms, that figure rises to approximately $6 million.

The additional $2 million in receivables represents cash that must be financed until customers pay.

Gewer sees this frequently among contractors serving large corporate customers.

“We work with businesses that have substantial contracts with very good customers. The work is profitable, but they need to pay people and suppliers well before they collect. If they win more work, their funding requirement grows. We’re interested in the receivables they’ve generated and the financial strength of the companies responsible for paying them.”

Factoring allows businesses to bring forward cash receipts from completed and invoiced work. It is particularly relevant where the availability of working capital limits the volume of business a company can undertake.

It is less suited to financing expenditure incurred before a receivable has been created, unless combined with other funding arrangements.

Who carries the credit risk?

The terms recourse and non-recourse are central to understanding how factoring works.

Under a recourse arrangement, the seller remains responsible for specified unpaid receivables. If the customer fails to pay, the factor may have the contractual right to require the seller to repurchase the invoice or reimburse the advance.

Non-recourse factoring transfers defined credit risks to the factor. At TowerCap, this includes the risk of an approved customer becoming insolvent, subject to the terms of the agreement.

This protection has limits.

A customer might withhold payment because the work was incomplete, the goods were defective, the invoice was disputed or a contractual deduction applies. Such circumstances are generally excluded from non-recourse credit protection.

Factors therefore examine more than a customer’s financial strength. They also assess the underlying contracts, invoice approval processes, payment history, possible deductions and the likelihood of disputes.

An invoice issued for work that has been completed and formally accepted is generally a different proposition from an unapproved progress claim or a balance subject to contractual retention.

These details determine which receivables are eligible for funding and the risks a factor is prepared to assume.

Must the customer know?

Traditional factoring commonly involves notifying customers that their receivables have been assigned to a factor. The factor may also manage collections and require payments to be remitted directly to an account under its control.

Non-notification factoring operates differently.

Under qualifying confidential arrangements, customers continue paying through an agreed account structure without being informed of the factoring relationship. The seller can maintain its existing commercial and administrative relationships, subject to the collection controls agreed with the factor.

TowerCap offers non-notification arrangements, particularly where established customer payment processes and invoice approval systems make them practical.

The availability of confidential factoring depends on the circumstances. It should not be assumed that every receivable or customer relationship will qualify.

Does factoring require the entire receivables book?

Some factoring agreements require companies to assign most or all eligible receivables, often with minimum volumes or contractual commitments.

Other facilities are more selective.

TowerCap allows businesses to choose which customers and invoices they wish to factor, with no minimum factoring volume or fixed lock-in period.

This can be useful for a business with different customer payment arrangements. It might factor invoices owed by a large corporate customer paying on 75-day terms while continuing to collect directly from customers who pay within 15 days.

Customer concentration also requires consideration.

Banks commonly assess concentration because substantial exposure to one customer can create risk for the borrower. Specialist factors also evaluate concentration, but may be willing to accept it where the underlying customer has sufficient financial strength.

TowerCap will consider funding receivables owed by a single customer.

The assessment remains dependent on customer credit quality, contractual terms, payment performance and the eligibility of the receivables.

Existing security arrangements can complicate matters. If a bank already holds a blanket lien over a company’s assets, including receivables, a factoring facility may require a release, consent or intercreditor agreement to establish the factor’s rights.

For companies with existing bank facilities, this should be addressed early in the evaluation.

How expensive is factoring?

Factoring is generally more expensive than conventional bank borrowing available to strong borrowers, although direct comparisons require care.

Providers use different pricing structures. Some charge a discount fee based on the face value of invoices purchased. Others apply periodic or daily charges according to how long an invoice remains outstanding. Additional administrative, due diligence or facility fees may also apply.

A fee of 2% of invoice value is not directly comparable with a 2% interest charge on a loan. In a factoring arrangement, the fee may be calculated against the full invoice value, while the amount initially advanced is lower. The duration of funding also matters.

A useful cost assessment should therefore establish the total dollar cost, the amount of cash made available and the period for which it is available.

It should also examine what services and risks are included in the price, particularly where non-recourse protection is provided.

For a business considering whether to factor, the calculation extends to the use of the released working capital.

If financing receivables allows a contractor to accept additional profitable work, obtain supplier discounts or avoid more expensive short-term funding, those benefits form part of the commercial assessment.

The additional margin must, of course, justify the financing cost.

Why does the knowledge gap persist?

Several factors may explain why factoring remains relatively unfamiliar to finance professionals, despite the longstanding use of receivables financing in business.

The first is professional exposure.

Most accountants and CFOs work regularly with bank facilities, secured lending arrangements and credit lines. Borrowing is an established part of corporate financial planning, with familiar processes for assessing debt capacity, negotiating covenants and managing repayment obligations.

Selling receivables involves a different set of contractual, operational and accounting considerations. Professionals who have never arranged such a transaction may have limited practical familiarity with its applications, even where they have considerable experience managing working capital.

The second factor is the diversity of factoring arrangements.

Terms such as invoice discounting, receivables financing, asset-based lending and factoring are sometimes used loosely, although they can describe materially different transactions. Within factoring itself, recourse provisions, customer notification requirements, collection arrangements and minimum commitments differ between providers.

A professional whose experience is limited to traditional, notified, full-ledger factoring may have little familiarity with confidential, selective or non-recourse structures. Assumptions formed through exposure to one type of facility can persist long after the range of available products has expanded.

The third factor concerns how factoring is distributed.

Factoring providers have historically worked extensively through commercial finance brokers and specialist intermediaries. These relationships are valuable because brokers understand the providers, their underwriting requirements and the circumstances in which a particular facility may be appropriate.

However, concentrating distribution through specialist intermediaries may also limit the industry’s exposure to the wider accounting and advisory professions.

Accountants, fractional CFOs, restructuring advisers and commercial bankers frequently encounter businesses with the financial characteristics that make factoring worth considering. Yet they may have little direct contact with factoring companies or limited awareness of how those companies evaluate transactions.

Reputation compounds these issues.

The association with distressed businesses and expensive last-resort finance remains familiar, despite the use of factoring by established companies to finance routine operations and growth.

Together, these factors offer a plausible explanation for the knowledge gap. They also suggest that broader awareness will depend on more than simply explaining the basic mechanics of factoring. Finance professionals need a clearer understanding of the different arrangements available, their accounting treatment, their costs and the circumstances in which they may be appropriate.

A missed opportunity for financial advisers?

Accountants, fractional CFOs, restructuring advisers and commercial bankers are often among the first professionals to recognise when a business is experiencing working-capital pressure.

They have access to the information needed to identify funding requirements: customer concentrations, receivables ageing, payment terms, collection performance, cash-flow forecasts and the availability of existing credit facilities.

In many cases, these same records provide the starting point for assessing whether factoring might be feasible.

A company with substantial receivables owed by financially strong customers, predictable payment patterns and a need to finance the period between invoicing and collection may be a candidate for factoring.

Gewer believes greater familiarity among these professionals would improve the financing options available to their clients.

“Often an adviser comes to us after the business has exhausted its existing bank facilities. Sometimes that’s the right time, but sometimes factoring could have been considered much earlier. If a company has good receivables and customers with strong credit, we’d certainly want to understand whether we can help.”

Factoring will not suit every business. Its usefulness depends on the quality of the receivables, the terms on which they can be sold, the costs of the facility and the company’s underlying financing requirements.

Greater familiarity with factoring will depend partly on the industry explaining its products more clearly, and partly on financial advisers recognising receivables sales as an established financing option.

For accountants and CFOs, much of the information needed for an initial assessment is already available in ordinary receivables reporting. The knowledge gap is therefore less about understanding the underlying financial assets than about familiarity with the arrangements available to finance them.

Given how much attention businesses devote to managing working capital, factoring deserves a more prominent place in those conversations.