Factoring is when a company sells its invoice to a third party to obtain quick financing or cash. Here the factoring company buys the invoices and provides businesses with a percentage of funding to be used as working capital.
There are many types of factoring, two of the most prominent ones being recourse and non-recourse factoring.
Meaning of Recourse Factoring
Recourse factoring is when the buyer is held responsible for the debt if its consumers fail to pay.
Usually, the factoring company takes on the burden to collect the payment on the seller’s behalf, but if it cannot, they can demand compensation from the seller.
In such a case, businesses buy back the invoice, i.e., repay the funds they are currently owed. Then they try to collect the debt from the customers themselves. Hence with recourse factoring also known as advance factoring, the risk lies in the hands of the seller.
Features of Recourse Factoring
There are several salient features of recourse factoring-
Higher Advance Rates With recourse factoring, the amount of funding a business receives upfront is higher since the risk lies with the business and not with the factoring company.
Cheaper Factoring Fee The factoring fee is less in recourse factoring than in non-recourse factoring.
Quick Funding Recourse factoring makes funds readily available to the business. As mentioned above, since the risk is associated with the company, the documentation and approvals are done quickly.
Easy Eligibility The eligibility criteria for recourse factoring can be easily met. Factoring companies will consider the customer's credit history more closely than that of the seller.
Working of Recourse Factoring
The working of recourse factoring is reasonably straightforward. Like any other factoring, the company will take its invoices to a factor that will apply for factoring.
Depending on the situation, the company will choose recourse and non-recourse.
Here, the buyer's history is considered since it will be the sole reason which might affect this decision.
If the buyer has a good credit history, i.e., if they pay on time, the company can take the risk on themselves and go for recourse factoring since they would be assured that the buyer will pay on time.
Once the invoice is given to the factoring company, they immediately provide the business with a percentage of the invoice. Now, when the due date for the invoice billing comes, the factor will collect the payment directly from the buyer of its client.
The factoring company can hold the business liable if the buyer cannot pay the invoice. The business will have to pay this invoice amount to the factoring company, after which it can try to retrieve the amount from the buyer.
One type of recourse factoring is undisclosed factoring when the consumer is unaware of the arrangement between the factor and the business.
If the buyer has a bad credit history or if they have a history of not completing their payments on time, businesses can choose to transfer the risk to the factoring company and opt for non-recourse factoring.
Once the invoice is submitted for factoring purposes, the company will receive the payment from the factoring company at a discounted rate, which they can use to carry on with their working capital.
An example of Recourse Factoring
Here’s an example to understand recourse factoring further. Let us assume that company A sells ₹1000 worth of goods to Company B, which will pay company A back after three months.
Now, company A sends a copy of an invoice to company C, a factoring company, which transfers ₹800 to company A on the same day.
After six months, the factoring company collects ₹1000 of the invoice. Once it deducts its commission, say 10%, i.e., ₹100 in this case, it returns the balance amount of ₹100 (1000-800-100= 100) to Company A.
Advantages and Disadvantages of Recourse Factoring
Advantages
There are various advantages to recourse factoring.
- Recourse factoring provides an easy option for businesses to advance the money of invoices without disrupting working capital.
- It is a cheaper factoring option for sellers since it is readily available with faster approval from factoring companies.
- The factoring fees are lower than non-recourse factoring.
- It is not shown as a debt in the balance sheet since factoring isn’t a loan.
Disadvantages
Though recourse factoring comes with its share of benefits, it also has a few drawbacks.
- Proper due diligence is required for such type of financing.
- If recourse factoring does not go as intended, it can hamper the business's financials.
Difference Between Recourse Factoring and Non-Recourse Factoring
Recourse and non-recourse factoring are both equally essential for a business. A business should consider these advantages and disadvantages when determining whether or not to pursue this kind of business funding.
Today, recourse factoring continues to be one of the most common options for small and medium businesses. A business can choose any of the two depending on the business's needs looking out for better ways to move towards financial growth.
