There are three parties in factoring. There is the factor that provides receivables financing by buying a client’s accounts receivables. There is also the client’s customers often referred to as debtors. When a company decides to use factoring as a source of working capital, a common question is who pays if the debtor decides not to pay his or her bill.
This is really a discussion of recourse vs. non-recourse factoring. In recourse factoring, if for any reason the debtor decides not to pay, the factor has recourse or protection against that debtor. In other words, the client (who sold his or her receivables to the factor) has no protection for non-payment. Conversely, non-recourse factoring provides a client protection against non-paying customers. This is, however, more expensive and less prevalent than recourse factoring.
Generally, a factor will look at the client’s “paper” or receivables and decide on a case-by-case basis whether providing recourse or non-recourse factoring. The factor will examine the debtors’ credit history, not the client’s. This is an important distinction and one of the selling points of factoring. A business is judged by its customer’s profile, not its own! You could have a less-than-stellar credit history, but if your clients are solid, you may be attractive to a factor.
A factor carefully investigates a potential client’s debtors before agreeing to do business.
“A factor typically does not buy non-performing paper,” says the Managing Director of Forward Business Credit, a receivable factoring company. “We are very pro-active in maintaining a reasonable degree of certainty that a debtor can pay and is willing to pay before we buy the paper from the client.”
With non-recourse factoring, a factor will protect itself with credit insurance if the client’s debtors go broke. For example, you are Company A, a client of a factor. Company A has a customer (a debtor) called Company B. Company B is having difficulty and has $500,000 in receivables due to Company A. The factor will protect itself by buying credit insurance that may protect it in case Company B goes insolvent.
Often, a factor promises non-recourse factoring up front to prospective clients, but the situation comes with caveats. First, this arrangement, as noted, is more expensive. Secondly, non-recourse factoring might not be available to all of a client’s customers. Company 1 has 100 customers. The factor may determine that only 15 are insurable. The remaining 85 debtors are, therefore, still exposed to Company 1.
In the end, credit insurance is not a recourse for factors to make bad business decisions.
“Credit insurance should not really be used by a factor as a hedge from buying paper it should not buy,” Marin observes. “It does not protect a client from returns, disputes or a dubious debtor. Generally, it only protects a client in the case of insolvency.”
If you are interested in improving your business’ cash flow through receivables financing or factoring, contact Forward Business Credit at (855) 424-2954.