Factoring - The Risks from the Other Side

A different perspective... say you are on the other side and you want to buy over the receivables of another company. With interest rates being so low, the returns seems attractive. What should you look out for?

Obviously the main risk is credit risk. Your client sells goods on credit to his customer and raises an invoice which he sells to you. The credit terms are stated say 90 days upon delivery. The customer's credit risk must be acceptable to you, otherwise why bother. But wait what if your client just wants financing and is willing to offer other tangible security say a mortgage over his Sixth Avenue bungalow at a reasonable loan to valuation ratio? Does that sound reasonable now?

It is useful at times to evaluate the key risks involved in different forms of factoring according to a risk matrix. The figure shown on the left differentiates the types of factoring transactions according to whether they are notified to customers and whether you have recourse to the client.

So Box 1 means your client must pay if the customer does not pay. You have also notified the customer. Notified has a strict legal meaning in factoring, it means you have informed the customer that you have bought over the debts, you own it and therefore only payment to you constitutes a discharge of the debt. You also set out your payment instruction. Box 1 seems ideal as you have the best of both worlds.

Box 2 is more classical. Here the client sells you the debt and says you take the full credit risk of the customer. If the customer's credit risk is acceptable and you have properly notified them you may choose to do so.

Box 3 is more of a loan deal than a factoring deal. Sometimes your client may not want his customer to know he is factoring his debts. But if his credit risk is good or if he willing to pledge tangible security or both, you may choose to finance him. Here you are actually lending your client monies, you cannot go after the customer because you have not notified him.

Box 4 sounds like a scam, you cannot notify the customer and your client will not pay you back in the event the customer does not pay. Really???

Tick off the boxes, you probably are only comfortable doing 1, 2 and 3.

Of course this is just a simplification but it helps you focus on where your risks are. Your client risk may not be acceptable but the customer is or conversely.

An added layer is credit insurance. Sometimes credit insurance is available for certain customers but you have to be comfortable with the terms of the insurance policy. That is a story for another day.

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