recourse factoring agreement

Recourse Vs. Non-Recourse Factoring

Last Updated on July 27, 2021

In order to survive in today’s competitive market and ultimately generate competitive edges, a company must weigh the short-term and long-term implications of various funding solutions. Cash flow is key to streamline operations, fulfill orders, maintain and gain market shares, and additional investments.

According to Bloomberg, the global market size of factor finance services is predicted to strike an overwhelming summit of $ 5,384.0 billion by the year 2027. And yet, for most small and medium-sized enterprises (SMEs), a major challenge is maintaining cash flow and working capital. This is where factoring can chip in as an alternative lending solution.

This article takes a comprehensive look at the two broad categories of factoring, the key distinctions between them, and the advantages and disadvantages of each. Let’s dive in.

What Is Factoring?

As you’re probably aware, factoring is whereby a firm (client) sells its invoices (accounts receivable) to a third-party factoring company (factor). Therefore, the client can receive its money faster than waiting for the customer (the debtor) to pay them directly.

The parties involved in a factoring agreement neither acquire nor issue debt as part of the transaction. Hence, factoring can’t be considered a loan.

Consequently, factor financing is quickly becoming a fashionable form of quasi-debt and a popular alternative form of financing. It has proven to be crucial for countless SMEs by fostering entrepreneurial ventures and greatly strengthening economic growth.

What Are the Two Types of Factoring

Every entrepreneur should know that there are at least two types of factoring arrangements- recourse factoring and non-recourse factoring. But before we even dissect each to find out their pros and cons, we need general insight into both. So, let’s define them:

a)   Recourse Factoring

With recourse factoring, the client is prompted to buy back any invoices for which the factoring company cannot collect payments. In order to cover unpaid invoices, it is advisable that the client sells the debt (debt factoring) to the factoring company at a discount.

If your liable customer fails to pay within some specified period, the factoring company may charge the invoice back to you or you can replace it with another good unfunded invoice. The factoring company effectively shifts the risk of non-payment to you.

b)   Non-Recourse factoring

Here, the factoring company will take on most of the liability of non-payment by the client’s debtors. And because of this, they’ll want steeper discounts on unpaid invoices. Essentially, there are specific situations in which your company is not responsible for customer non-payment.

It is worth noting, however, that the client is not absolutely immune from all risk. Non-recourse factoring has associated provisions. Typically, most factoring companies offer non-recourse in the exclusive case of debtors who declare bankruptcy.

Still, such debtors must have good credit ratings to be considered. While the factoring company gives a credit guarantee that they are responsible for collecting your invoices, there’s no warranty that you are hedged against products or services disputed by clients.

So, in a nutshell, non-recourse factoring is distinguished from recourse factoring in that the factor accepts the non-payment credit risk of your clients.

The Pros and Cons of Each

A Forbes publication explains that even profitable businesses are not left out when it comes to dealing with cash flow problems, especially those with long payment cycles. Most companies affected by such will rely on factoring as an alternative form of financing. The big question is: which is the best choice for your business?

Savvy entrepreneurs understand that it is important to cover the downside and let the upside take care of itself. With that in mind, it is important to weigh the advantages against the disadvantages of each before making a final decision.

1.    Merits of Recourse Factoring

Recourse factoring is perhaps the most commonly chosen, and here are its advantages:

  • Enhances quick cash flow for immediate needs.
  • The client has no obligation to handle collections.
  • The cheaper option for invoice sellers due to smaller factor fees.
  • Stimulates greater business cash flow due to more cashback from invoices.
  • Faster approval process.
  • The factor is tasked with credit checks and in-depth verification of invoice clients to minimize the risk of defaults.
  • The client can either pay back “bounced” invoices or have them exchanged with others upon default.
  • The factor may avail options to help cover the cost of recourse on the client’s part.
  • It leaves no debt on the client’s balance sheet as it isn’t a loan.

2.    Demerits of Recourse Factoring

Nobody wants to take a blind pick without a clear picture of the downsides. So, here’s a highlight of the most prominent ones:

  • Less tight credit checks are done on the client’s debtors; the factor may enjoy recourse and has less risk in the event of non-payment.
  • If a client fails to settle the default promptly or offset it with a good invoice, it could take a toll on their business income and bank accounts.
  • Invoice offered in exchange for an unpaid one has higher pricing.

3.    Merits of Non-Recourse Factoring

On the upside, non-recourse factoring is characterized by:

  • High level of bad debt protection for the client
  • Enhances cash flow and working capital
  • Clients can provide payment terms to their debtors
  • The factor is tasked with credit checks and in-depth verification of invoice clients to minimize the risk of defaults.
  • Relatively easy to get funding compared to alternatives like a business line of credit (LOC)
  • Simple application & fast deployment
  • Can be open for short term funding, say three months

4.    Demerits of Non-recourse Financing

Some drawbacks worth examining are as follows:

  • The level of bad debt protection varies among companies
  • Non-recourse factors may impose rigorous measures prior to financing invoices
  • Costs more than alternative forms of financing say bank financing
  • Demands higher discounting of invoices

Wrapping Up

A client should engage in a detailed discussion with a reputable factor on the latter’s terms regarding each type of factoring. And generally, to incur lower fees and worry less about risks, the best option is to ensure debtors have solid payment histories and impressive credit ratings.