Factoring – what is it and how to use it?

Factoring has become a popular financing tool for modern businesses looking for liquidity. What is behind the term and what benefits can it bring to your business?

In this article you will find out:

• What is factoring?
• What are the types of factoring?
• What are the legal aspects of factoring?
• What are the relationships between factoring and other sources of financing?
• How to choose a factoring company?
• What affects the costs of factoring?
• What are the disadvantages of factoring?
• What can be gained from factoring?

Factoring – definition

Factoring is a financial service in which a company sells its receivables (e.g. invoices) to a factor (that is, a specialised financial institution) in exchange for prompt payment. In practice, this means that the company receives money from the factor for its invoices before their due date, which can improve the company’s liquidity. There are three main parties involved in the factoring process:

• The seller (the factor’s client) – the company that provides goods or services to its customers on credit and then sells them to the factor in order to receive prompt payment. It usually uses factoring to improve liquidity and minimise the risk of late payment or insolvency of its customers.
• A factor (factoring institution) – is a specialised financial institution (it can be a bank or an independent company specialising in factoring services) that buys receivables from a seller. The factor pays the seller an immediate amount based on the value of the invoice (usually a percentage of the value of the invoice and the balance is paid when the full amount is collected from the debtor, less a factoring service fee). Depending on the type of factoring, the factor may also assume the risk of the debtor’s insolvency.
• The debtor (recipient) – is the customer of the seller who has received goods or services on credit and is obliged to pay for them on the basis of an invoice issued. Once this invoice has been sold to the factor, the debtor is obliged to make payment directly to the factor rather than to the original seller.

The factoring process usually works as follows – the seller provides the goods or service to the debtor, issues an invoice and then sells this invoice to the factor in return for immediate payment. When the invoice due date arrives, the debtor makes payment directly to the factor.

Factoring is a financial service whereby a company sells its receivables to a factoring company in exchange for prompt payment.

Definition of factoring

Types of factoring

Factoring can take different forms, depending on the specific needs and agreements between the parties. Here are the most common types of factoring:

• Factoring with recourse – if the debtor does not pay the invoice by the agreed date, the factor can claim back from the seller the funds previously paid. This means that the risk of the debtor’s insolvency rests with the seller.
• Non-recourse factoring – the factor assumes the risk of the debtor’s insolvency. If the debtor does not pay the invoice on time, the factor will not be able to claim reimbursement from the seller.
• Domestic (domestic) factoring – applies to invoices issued to customers from the same country as the seller.
• International (export) factoring – covers invoices issued to customers from other countries. It is used when the seller exports goods or services abroad.
• Incomplete (selective) factoring – the seller decides which specific invoices it wants to sell to the factor, rather than selling the entire pool of invoices.
• Reverse factoring (reverse factoring) – is initiated by the debtor (rather than the seller). The debtor (often a large company) indicates which invoices issued by its suppliers are to be paid by the factor before the due date. In practice, this helps the debtor to manage payments and improve its relationship with its suppliers.
• Factoring without notification (silent) – in this case, the debtor is not informed of the sale of the invoice to the factor. Payment from the debtor is still made to the seller, who then transfers the funds to the factor.
• Factoring with notification – the debtor is informed of the factoring transaction and is instructed to make payments directly to the factor.
• Factoring with services – in addition to financing, the factor offers additional services such as receivables management, accounting services or debt collection.
• Matrix factoring (bulk factoring) – involves the sale of an entire portfolio of receivables to a factor, rather than individual invoices.

Legal aspects of factoring

Factoring is associated with a number of legal aspects that define and regulate the relationship between the parties involved. The most important document is the factoring agreement between the seller and the factor – it defines, among other things, the fees, the risk of insolvency of the debtor and the rights and obligations of both parties. The key to it is the transfer of the receivables from the seller to the factor, which in many jurisdictions must be done in writing.

Depending on the type of factoring, the debtor may be notified of the sale of its debt, meaning that it is obliged to make payment to the factor rather than the original seller. In some cases, the factor may also require additional security, such as sureties or guarantees. Due to the sensitivity of certain information, many factoring agreements contain confidentiality clauses.

It is also important to note that, in some countries, factoring institutions are regulated and supervised just like banks or other financial institutions. Factoring transactions may also affect the company’s taxation, which applies to both income tax and VAT. As for conflicts and disputes related to the factoring agreement, many of them contain provisions on mechanisms to resolve them, such as mediation or arbitration.

In Poland, factoring is not defined as a banking activity, which means that no authorisation from the NBP or the Polish Financial Supervision Authority is required to conduct factoring. It is also worth noting that a factoring agreement is not listed in the Polish Civil Code, so it can be shaped quite freely. Factoring agreements are treated by Polish law as non-named agreements, so the provisions of the Civil Code concerning such agreements and the European Contract Law apply to them.

Factoring versus other sources of financing

Factoring is one of the many sources of financing available to businesses. Like bank loans or leasing, it primarily serves to provide additional funds to a company. Factoring, however, focuses on financing based on receivables from counterparties, i.e. invoices for goods or services supplied. This allows a company to receive payment for its products or services more quickly, without waiting for the invoice to mature. In the case of a bank loan, a company takes on a liability that it must repay over a certain period of time with interest. Leasing, on the other hand, involves the financing of fixed assets, where the leased item is owned by the lessor until the end of the contract.

Furthermore, factoring often involves the factor assuming the risk of the debtor’s insolvency (in non-recourse factoring), whereas with a bank loan the risk of non-payment usually remains with the company. Companies often combine different financing methods to optimise costs and access to capital. For example, a company may use factoring to finance day-to-day operations, while it may take out a bank loan for long-term investments.

Choosing a factoring company

The first step in choosing a factoring company is to identify the exact needs of your business. Consider exactly what you want and the type of factoring you are interested in. Next, conduct market research to identify the factoring companies available. In doing so, it’s worth checking out reviews and testimonials from other customers – the experience of other businesses can be one of the main factors in choosing a particular factoring company.

Then compare the offers from different companies. Focus not only on fees and margins, but also on additional services such as receivables management or insurance. Carefully review the terms and conditions of the contract and make sure you understand all clauses, especially those relating to payment terms, liability for debtor insolvency and the possibility of termination.

If you are unsure of your choice or want to be sure you understand all aspects of the contract, it is worth consulting a lawyer or financial adviser. Once you have chosen a company, proceed to negotiate the terms Once you have agreed the terms and accepted the offer, you can proceed to sign the agreement with the factoring company. Then carry out the implementation of the new process in your company and make sure your team is aware of the new procedures.

Factoring costs

The costs of factoring are varied and depend on many factors. Here are the main elements that affect the cost of factoring:

• The factoring fee (factoring margin) is a percentage fee charged on the value of the invoice that covers the services provided by the factoring company.
• Discounting interest – when the factoring company pays the trader earlier than the due date on the invoice, it charges interest on the financed receivables. The interest rate is usually linked to the underlying market interest rates and the credit risk of the business.
• Insurance costs – in the case of non-recourse factoring, where the factoring company assumes the risk of the debtor’s insolvency, it may charge additional fees for receivables insurance.
• Additional charges may include costs related to credit analysis of debtors, fees for outstanding receivables or costs related to handling receivables in different currencies.
• The length of the contract and the volume of transactions are among the most important factors affecting factoring fees. Factoring companies may offer more favourable terms for companies that choose to work together for longer or transfer a larger volume of receivables for factoring.
• Factoring costs may be higher for industries with a higher risk of insolvency or for companies that have a history of payment problems. Also, competition in the factoring market affects the final costs.

Disadvantages of factoring

Factoring can bring an immediate improvement in liquidity, but it does not solve a company’s underlying financial problems. If your company has deep profitability or management problems, factoring can only mask these issues.

One of the main disadvantages of factoring is its costs – these can be higher compared to other forms of financing. Factoring fees, discounting rates and potential ancillary fees can add up, making factoring less attractive for some businesses. A second disadvantage is the potential market perception – the use of factoring by some companies may be seen as a sign of financial problems, which can negatively affect business relationships.

Another problem is the limitation of control over the collection process, and the collection methods used by the factoring company may affect your company’s customer relationships. It is also worth remembering that factoring companies do not have to accept all invoices – they may, for example, reject receivables from debtors with high credit risk.

Benefits of factoring

Factoring can be tailored to a company’s individual needs, whether in terms of the volume of invoices or the terms of the contract, and using factoring can allow your company to focus on its core business. It also improves a company’s liquidity by providing quick cash for invoices that may not be paid for several weeks or even months. This allows businesses to dispose of funds more quickly, making it easier to cover ongoing costs or invest in growth. In addition, it minimises the risk of counterparties becoming insolvent, as the factoring company assumes the risk of non-payment of the invoice.

Factoring can also contribute to more efficient management of receivables. The added value of access to analysis and credit ratings of debtors cannot be overestimated either, and by working with a factoring company your company can better assess the risk of working with new counterparties.