Factoring

Factoring: Using Receivables as an Immediate Source of Cash

At times a company will need to convert its receivables to cash immediately. One of the company’s options is to “sell” its accounts receivable. Receivables are sold by selling them to a “factor,” a type of commercial finance company. The factor essentially makes a loan to the seller of the receivables that is guaranteed (collateralized) by the receivables.

Receivables can also be used as a source of cash by assigning or pledging them as security for a loan.

Pledging receivables as security for a loan does not actually involve selling them.

However, selling its accounts receivable differs for the seller from borrowing money and pledging the receivables as collateral in two ways:

• After it sells its receivables to the factor, the seller of the receivables no longer owns the receivables, so the receivables are removed from the seller’s balance sheet.
• The seller also does not report a loan outstanding on its balance sheet for the funds received in the sale of the receivables.

The factor notifies the seller’s customers to begin remitting their payments directly to the factor, and the factor receives repayment of its “loan” as it collects the receivables.

The two forms of factoring are called “without recourse” and “with recourse”

Traditionally, factoring is without recourse, which means the factor assumes the risk of any credit losses on the receivables. If a receivable the factor purchased proves to be uncollectible, the factor has no recourse against the seller of the receivable—the loss is the factor’s loss. Some companies factor their receivables without recourse to transfer the credit loss risk in this manner. However, the greater the risk of credit losses, the less cash the selling company will receive from the factor.

If the receivables are sold without recourse, any credit loss expense and balance in the allowance for credit losses account already recorded by the seller for the receivables needs to be reversed.

Sometimes the sale is with recourse. In a sale of receivables with recourse, if a customer does not pay the receivable, the seller of the receivable is liable to the factor for the credit loss. Therefore, when a factor purchases receivables with recourse, the factor’s risk of credit losses is limited. Because of the lower level of risk to the factor, it will pay more when buying receivables with recourse.

If receivables are factored with recourse, the seller will carry a liability, called recourse liability or recourse obligation, on its balance sheet for the estimated amount of any expected credit losses. The recourse liability is very similar in process to the allowance for credit losses account used by a company that collects its own receivables and bears the risk of the associated credit losses.

A company will not be able to sell its receivables for the full amount of their face value, however. The factor takes some of the value of the receivables as fees for its service provided. Furthermore, if the factor purchases the receivables without recourse and thus assumes the risk of credit losses, the amount the selling company will receive for its receivables will be even more reduced.