Receivables finance: An Overview
Sellers face a major problem when buyers prolong their invoice payment for weeks or even months in some cases. In addition to running the risk of buyers not giving them full payment at the due date of the invoice, sellers must also fill the cash flow gaps that occur during this period.
Receivables finance offers a simple yet effective way out of this tricky financial situation for the sellers. It allows them to sell their outstanding invoices to finance providers or factors at a discounted rate. This way, sellers receive the remaining invoice amount before the due date of the invoice. The factors get their money back at invoice maturity through the sellers, acting as collecting agents, or directly from the debtors.
How does it work?
Sellers deliver goods and services to buyers and request that lenders fund the outstanding invoices. The factors (financers) look at the invoice, perform the cost and benefit analysis and evaluate the risks of debtors before providing a cost of finance to the seller; or putting a finance facility in place. Receivables finance takes many forms, but usually the true sale (where there is no recourse to the supplier) is seen as receivables purchase. Once a facility is set up and the seller elects to discount or sell a receivable, the buyer pays the seller a nominal amount at a discounted rate known as receivables discounting. The remaining invoice amount is collected at the due date of the invoice by the seller and given to the factor. The diagram (figure 1) below illustrates how receivables factoring operates.
There are two main types of receivables factoring:
- Invoice discounting: This type of receivables factoring involves a business choosing to sell its invoices to a factor and receiving the cash before the due date instead of waiting for a period of time. The responsibility of handing out the bill to its customers and collecting the payment on the due date falls on the shoulders of the business or seller.
- Factoring: There is only one major difference between invoice discounting and factoring, that is, the finance providers are responsible for chasing payments or collecting them at the due date from the buyers. Factoring is employed by smaller businesses, which do not have resources like a specialist credit control team to collect or chase payments.
- Sellers do not have to wait for the payment of invoice as factors pay invoices before invoice maturity at desirable discounts.
- The early sale of receivables diminishes the risk positions associated with debtors.
- Sellers are able to better manage their cashflow and do not have to worry about bridging liquidity gaps as receivables finance helps to free trapped liquidity.
- Receivables factoring allows firms to expand their business by allowing debtors prolonged credit terms.
- Sellers also receive insightful advice from factors about the credit strength of the debtors which assists them in striking better deals in future.
- Receivables finance includes the translation of a company’s debts into cash without having any unwanted effects on the company’s business.
- Profit from goods is reduced significantly as the factor deducts a certain amount from the value of accounts due to be received, as fees for the service provided. In addition to this, interest is also charged on the advance made in some cases, which results in a loss of profit on the final amount.
- Risks such as the credit wellness of the factor are beyond the control of the seller. A factor may withdraw credit advances due to poor credit ratings of a party in question.
- Following the discounting of a receivable, the seller is no longer due the receipt of a payment from the customer. The seller also has no control over the book debts. This asset can no longer be provided as collateral while acquiring another type of finance.
- In the case of recourse factoring, the seller’s liability is not completely waived. If a financier is unable to recover their debt from the factor, then they are legally entitled to obtain it from the seller. This leaves the seller liable to pay the factor, in case of non-payment. Such a situation would impact business projects already under execution.
- Factors comes at a cost and may be more expensive than other forms of finance.
- The buyer may not be willing to involve a third party factor or lender, due to their professional and strict dealing methods. Agencies send weekly reminders to the buyers for their debt, which will result in loss of personal touch that may present a negative image of the seller. Due to this the buyer may consider switching vendors which will be damaging to the seller.
Key Case Study: Virtual Creators Inc
Virtual Creators is a hardware start-up that is looking to expand its business. This firm sells its goods in mass quantities to online and brick & mortar retailers. They produce their goods in Shenzhen and have recently moved to a new producer in the region. Virtual Inc does not have any prior affiliation with this new manufacturer. The latter does not offer trade credit and requires immediate payment on the arrival of goods at the U.S. port.
Virtual Creators keeps its gross margins fixed at 40% at wholesale to their retail buyers. However, the retailers do not pay before the end of 60-day period after getting the product. Virtual Inc depends upon receivables finance to generate the cash required for the immediate payment that its manufacturer needs upon the arrival of goods at the U.S. port.
- Does receivable finance build one’s business credit profile?
- Business credit will not be built because of receivables factoring. This is due to the fact that the secondary buyers are not expected to report back to the credit officers.
- Who can access receivables factoring?
- Companies or businesses who are selling products or services to other businesses