Receivables and credit policy - Factoring and invoice discou...

Learning Outcomes

After reading this article, you will be able to describe the role of factoring and invoice discounting in credit policy, explain how each works, compare the advantages and drawbacks, and evaluate their suitability as receivables management tools. You will also be able to calculate key impacts and identify relevant exam requirements for the ACCA FM paper.

ACCA Financial Management (FM) Syllabus

For ACCA Financial Management (FM), you are required to understand techniques for managing accounts receivable, including factoring and invoice discounting. You should focus your revision on:

• Explaining and applying relevant techniques in managing accounts receivable, specifically factoring and invoice discounting
• Evaluating advantages and disadvantages of using factoring or invoice discounting as sources of receivables finance
• Discussing the operational, financial, and risk management impacts of different credit policies
• Calculating and interpreting the financial effects of changes in receivables management strategies

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What key difference exists between factoring and invoice discounting in terms of customer communication?
2. Which cash flow impact is most immediately improved by using a factoring arrangement for receivables?
3. True or false? A company always transfers irrecoverable debt risk to the financier when it uses invoice discounting.
4. Briefly explain one advantage and one disadvantage of factoring for a high-growth small business.

Introduction

Receivables are a major component of working capital, and the speed and certainty with which amounts owed are turned into cash can significantly affect liquidity and profitability. As businesses grow, managing receivables efficiently becomes essential but can also increase administrative burden and exposure to bad debts.

To support working capital needs and reduce administrative tasks, companies often consider third-party services such as factoring and invoice discounting. Both offer ways to convert receivables into cash more quickly, but each has features that suit different business objectives and risk preferences.

Key Term: factoring
The process of selling trade receivables to a third-party (the factor) that collects the debts and may provide immediate cash, with or without taking on bad debt risk.

Key Term: invoice discounting
A financial arrangement where a business borrows cash against outstanding invoices, using receivables as security, while retaining responsibility for credit control and debt collection.

Receivables Management and Credit Policy

Efficient receivables management improves cash flow, reduces bad debt risks, and can create business growth opportunities. Credit policy decisions involve striking a balance between higher sales volumes (by extending credit) and the risk/cost of delayed or irrecoverable payments.

Key methods of financing and managing receivables include:

• Offering early settlement discounts to customers
• Factoring
• Invoice discounting

Factoring

Factoring is a comprehensive service in which a business sells its trade receivables to a factor. The factor usually provides several services:

• Financing: Immediate cash payment, often up to 80% or more of the invoice value
• Sales ledger administration and collection of debts
• (Optionally) credit insurance to protect against bad debts

Factoring agreements can be structured as:

• Recourse factoring: The company retains the risk of non-payment (the business makes good any irrecoverable debts)
• Non-recourse factoring: The factor assumes the risk of receivables not being paid

Factoring services are typically disclosed to customers. Customers pay the factor directly.

Key Term: recourse factoring
A factoring arrangement where the business remains liable for bad debts if customers fail to pay.

Key Term: non-recourse factoring
A factoring arrangement in which the factor bears the risk of bad debts and the business is not liable if customers default.

Invoice Discounting

Invoice discounting is an arrangement where a business raises finance by using its invoices as security for a loan from an invoice discounter. Key points:

• The business retains control over its sales ledger and customer relationships
• The invoice discounter advances a percentage of the invoice's value (typically up to 80%)
• The service is usually confidential (customers are unaware)
• The business continues to collect the debts; repayments are made as cash is collected

Invoice discounting generally does not provide sales ledger administration or bad debt protection, and it is often only available to businesses with an established track record and robust credit control systems.

How Factoring and Invoice Discounting Work

Both services accelerate cash inflows, but differ in administration, confidentiality, and risk transfer.

Costs

Fees are charged for both the finance (interest or charge on advanced amount) and any additional services (administration, insurance). Total cost usually consists of a percentage of sales plus interest on funds advanced.

Benefits and Risks

Benefits

• Immediate improvement in cash flow and working capital
• Outsourcing of receivables collection (factoring)
• Reduced exposure to bad debts (non-recourse factoring)
• Potential for administrative cost savings
• Can support business growth, especially where internal resource is limited

Risks and Drawbacks

• Cost can be significant, especially for smaller or higher-risk businesses
• Perception that factoring indicates financial weakness
• Loss of direct control over customer relationships (factoring)
• Confidentiality may be lost (factoring)
• Businesses remain responsible for irrecoverable debts unless non-recourse factoring is used

Worked Example 1.1

A business with annual sales of $4 million and average receivables of $650,000 is considering factoring its debts. The factor will advance 80% of the value of receivables, charges a 2% service fee, and funds advanced incur a 7% interest rate. Administration savings of $12,000 per year are expected. Should the company take the offer if bank overdraft interest is 7%?

Answer:

• Service fee: 2% × $4,000,000 = $80,000
• Lost interest on $650,000 × 80% = $520,000 funded; both factor and bank charge interest at 7%, so no cash saving.
• Administrative saving: $12,000
• Net cost: $80,000 – $12,000 = $68,000 per year If financing needs are unchanged, factoring increases cost; however, if factoring brings reduction in overdue debts or absorbs bad debt risk, strategic benefits may outweigh pure cost.

Worked Example 1.2

Company X is weighing invoice discounting for $1.6 million of eligible invoices. The discounter offers up to 85% advance, charges 1.2% of turnover plus base rate + 3% on sums advanced. Company X wants to maintain existing customer relationships and confidential trading.

Answer:
Invoice discounting suits Company X, as it is confidential and preserves customer relationships. However, company X must retain credit control skills and absorb any bad debts.

Exam Warning

Be alert: Invoice discounting is NOT risk transfer. Unless the agreement explicitly includes bad debt protection, the business remains responsible if customers do not pay. Only non-recourse factoring transfers the risk of irrecoverable debts.

Revision Tip

In exam scenarios, always identify whether factoring is with or without recourse. Many answers fail for not making this distinction clear.

Summary

Factoring and invoice discounting can both improve cash flow using receivables as a source of short-term finance. Factoring offers a suite of administrative services, potential risk transfer, but reduces confidentiality and direct customer contact. Invoice discounting is suitable for larger or well-established businesses seeking confidential funding and wishing to keep credit control in-house. Consider cost, control, confidentiality, and risk before recommending either option.

Key Point Checklist

This article has covered the following key knowledge points:

• Define factoring and invoice discounting as receivables finance mechanisms
• Distinguish recourse and non-recourse factoring
• Explain how factoring and invoice discounting work in practice
• List main advantages and disadvantages of each method
• Calculate main financial effects and discuss how to appraise their use in an exam context
• Identify exam-relevant distinctions: service scope, bad debt risk, and customer communication

Key Terms and Concepts

• factoring
• invoice discounting
• recourse factoring
• non-recourse factoring