## **Learning Outcomes**

After reading this article, you will be able to explain the structure and operation of factoring as a method of receivables financing for ACCA FM. You will distinguish between factoring with recourse and without recourse, identify their implications for credit risk, and evaluate the advantages and disadvantages of each approach from both the company’s and the factor’s viewpoint.

## **ACCA Financial Management (FM) Syllabus**

For ACCA Financial Management (FM), you are required to understand the key techniques for managing accounts receivable. Focus your revision on:

- The use of factoring and invoice discounting as receivables financing techniques
- The distinction between with-recourse and non-recourse factoring, and their impact on risk
- The implications of factoring for working capital management and cash flow
- The benefits, limitations, and risks of factoring arrangements
- Evaluation of appropriate receivables management methods in practical scenarios

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What is the main difference between factoring with recourse and without recourse?
2. How does factoring improve a company’s liquidity position?
3. Name two typical services a factor provides other than lending cash.
4. True or false? Under non-recourse factoring, the factor bears the risk of customer default.

## **Introduction**

Effective receivables management is essential to ensure that businesses collect cash promptly from customers. One common technique used to accelerate cash inflows and manage credit risk is factoring. Companies facing long collection periods, risk of bad debts, or rapid sales growth often require external support to finance their receivables.

Factoring is the sale of accounts receivable to a third party (known as the factor) in exchange for immediate cash. There are two main types of factoring arrangements: factoring with recourse and factoring without recourse. The allocation of credit risk between the business and the factor has significant implications for financial management.

> **Key Term: factoring**
> The process by which a company sells its accounts receivable (trade debts) to a third party (factor) to receive immediate cash, often with additional services such as sales ledger administration and collection.

## **Factoring Arrangements**

Factoring involves more than just lending cash against receivables. Typical factoring services may include:

- Immediate advance of a percentage of receivables (often up to 80%)
- Collection of outstanding payments from customers
- Administration of the sales ledger
- Credit risk protection (in some cases)

Depending on the specific agreement, the company may transfer some or all of the risks and responsibilities associated with non-payment by customers to the factoring company.

> **Key Term: recourse factoring**
> A factoring arrangement where the client company bears the risk of non-payment; if a customer does not pay the invoice, the client must reimburse the factor.
>
> **Key Term: non-recourse factoring**
> A factoring arrangement where the factor assumes the risk of customer default; if a customer fails to pay, the factor absorbs the loss.

## **Factoring With Recourse**

In recourse factoring, the business remains liable for any debts that customers fail to pay. The factor provides cash up front (usually a percentage of the invoice value), manages the sales ledger, and collects payments, but if the customer ultimately defaults, the business is required to reimburse the factor.

Key features:

- Company ultimately retains the risk of bad debts
- The factor may charge lower fees (less risk for the factor)
- Recovered cash will be reclaimed from the company if necessary
- Not suitable for companies seeking to insure against customer default

## **Factoring Without Recourse**

In non-recourse factoring, the factor takes on the risk of customer non-payment. If a customer defaults, the factor cannot claim repayment from the company. This arrangement effectively insures the company against bad debts on the receivables sold.

Key features:

- Factor absorbs the risk of customer non-payment
- Suitable for companies wishing to eliminate the risk of irrecoverable debts
- Higher fees reflecting greater risk assumed by the factor
- Often subject to stricter credit control and verification by the factor

## **Advantages and Disadvantages of Factoring**

### For the Client Company

**Advantages:**

- Immediate injection of cash (reduces need for overdraft)
- Outsourced sales ledger and debt collection
- Professional credit control and possible reduction in irrecoverable debts
- In non-recourse arrangements, transfer of bad debt risk

**Disadvantages:**

- Loss of direct control over customer relationships
- Factoring services cost (fees and discount charges)
- In recourse factoring, remains exposed to bad debts
- Customer perception of company’s financial health may be affected

### For the Factor

- Potential for steady fee income from administration and lending
- Exposure to credit risk (only in non-recourse arrangements)
- Need for careful assessment of the client company’s and customers’ credit risk

### **Worked Example 1.1**

A manufacturing company sells \$500,000 of goods per month on 60-day credit terms. It is considering entering into a non-recourse factoring agreement. The factor offers to advance 80% of the invoice value immediately at an annual fee of 2% of turnover and a 6% discount rate. The company currently incurs \$8,000 per year in bad debts and spends \$12,000 annually on credit control.

**Should the company use non-recourse factoring?**

> **Answer:**
> The company would receive \$400,000 (80%) of its monthly sales as immediate cash, improving working capital. It would save \$8,000 in bad debts and \$12,000 in credit control costs each year. However, factoring fees and discount charges must be compared to these savings for a final decision. Additionally, the company is protected from bad debts, which is valuable if customers are risky payers.

### **Worked Example 1.2**

A wholesaler factors \$1,200,000 of receivables each year under a recourse agreement. The factor advances 85% of invoice value and collects a 1.5% administration fee plus 5% finance charge on amounts advanced. The company does not have a history of bad debts. Is recourse factoring appropriate compared to their current system?

> **Answer:**
> With recourse factoring, the company gains earlier access to cash and professional credit management but remains responsible for any non-payment. Since the company experiences minimal bad debts, recourse factoring may be an economical option as factor fees are lower compared to non-recourse, but benefits beyond cash flow and administration are limited.

### **Exam Warning**

> Be clear about who bears the bad debt risk in each arrangement. In recourse factoring, the company remains liable for non-payment; in non-recourse factoring, the factor assumes this risk. Do not confuse the two in exam answers.

## **Summary**

Factoring is a practical receivables financing method offering both liquidity and additional credit management services. The key distinction is the allocation of bad debt risk: recourse factoring leaves risk with the client, while non-recourse transfers it to the factor. Companies must weigh the costs and benefits of each approach, given their own risk tolerance and the creditworthiness of their customer base.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define factoring and describe its main features
- Distinguish between recourse and non-recourse factoring
- Explain the allocation of credit risk in factoring agreements
- Evaluate the advantages and disadvantages of factoring
- Recognise how factoring can improve working capital management

## **Key Terms and Concepts**

- factoring
- recourse factoring
- non-recourse factoring

Receivables financing structures - Factoring with and without recourse