Maximising Cash from Factoring

For many corporates, the signing of the all-important Factoring Agreement signals the end of much hard work in finding a Factored Receivables lender, gaining credit approval and negotiating the commercial legal terms and legals, after which a reliable and consistent stream of cash can be expected to flow into the company bank account every week.

Sadly it’s not as simple as that, and as I have seen over many years in managing and improving underperforming corporate Factoring schemes, it’s the operational process itself and contractual small print that can cost a business up to 40% of its anticipated factored cash flows.  Experience shows that many corporates pay little or no attention to the finer detail of maximising Factoring flows thus missing out on additional liquidity, incurring higher than expected costs per € or £ of borrowing (“borrowing efficiency”), and even experiencing financial pressure that the Factoring was supposed to address.  So why does this happen and how can it be avoided?

This is also the moment where the bank steps back, as they are not equipped (and do not expect) to work closely with their customer’s back office to ensure that the funds released by factoring are as high as they could possibly be.

Here are the main problems experienced by corporates in maximising Factored receivable cash flows, which are then examined in more detail in the sections that follow:

• Poorly negotiated receivable reserve provisions in the contract
• Incorrect segregation of factored and non-factored receivables in the General Ledger
• Incorrect IT programming against the banks file specifications
• Lack of active management of the factored invoice portfolio
• Issues related to credit insurance
• Reserves under Factoring Contracts

When negotiating the initial factoring contract, it is essential that corporates read the commercial breakdown of all items and events that permit the bank to withhold sums of money from the factored loan advances issued against each assignment of invoices. The main withholding situations that the bank is seeking should be outlined in the Terms Sheet outlining the main points of the facility.

The table below shows the most common examples of items which could inadvertently cause excessive withholding of funds, the borrower should look at the terms of each in detail and challenge the bank where its assumptions look to be overly aggressive

Contractual Reserve – Typically 10% up to a max of 20% – represents the amount that the bank considers necessary to cover any default events under the agreement.
Sometimes the bank will specify “10% of factored receivables or a minimum of € X whichever is the greater; the danger is setting the minimum withholding amount to high so that the borrower consistently suffers greater than 10% withholding.
Mitigant Use whatever evidence (e.g. low past due aged debts as % of total receivables, past borrower financial history), available to minimise the rate as close to 10% as possible.

Concentration Reserve – Additional entitlement to withhold funds if the total receivables of a customer or group exceed x% of the factored receivables. Typically a 15-20% concentration would trigger an additional withholding.
This can be a particular problem in a seasonal business where one customer may appear to have a dominant concentration of receivables at certain times of year due to cyclical buying behaviour.
Mitigant: The borrower needs to understand its concentration risk early in the negotiations; if concentration risk is due to highly reputable customers it may be possible to improve the concentration measurement, also it may be able to negotiate a grace period for exceeding concentration limits within which the withholding will not be applied.

Unpaid / Disputed Reserve – Allows the bank to reserve 100% of the invoice when its ageing goes beyond a certain limit (e.g. 60 days past due).
Aged debts are an underappreciated issue in factoring, as funding relies on a continuous recycling of old debts for new ones. When a debt goes past the contractual ageing, the bank will deduct any unreserved amount from the next available loan advance, therefore reducing the recycling of the borrower’s working capital. Conversely collecting debts within the permitted ageing will release any reserves as cash to the business.
Mitigant: Factored receivables should be treated equally to all other receivables in the credit and collection process; poorly performing factored receivables could lead to the bank wishing to take additional reserves, whilst strongly performing receivables can enable improved terms and pricing upon renewal.

Rebate Reserve Additional – claw back used where borrowers have bonus and/or rebate type arrangements with customers (e.g. volume purchase rebates), to protect the bank against customer deductions against payment of receivables; the amount of the reserve is linked to the percentages allowed on the sales contracts.  The bank will also look to build reserves where rebates are paid by the borrower in lump sums.
If the borrower underestimates the rate of rebates in its sales ledger, this can seriously reduce the amount available to borrow, or result in the bank imposing additional withholding to cover greater than expected risk of collecting the full invoice amounts.
Mitigant: The borrower needs to quantify its rebate levels early in the negotiations and be prepared to challenge the bank’s assumptions if considered too high.  IT systems often need special configuration to be able to recognise rebate deductions during the cash application process to enable accurate reporting to the bank; otherwise, there could be a build up of borrowings against funds that have in fact been kept by the customers.

Specific Reserves – ‘Other’ amounts that the bank may set aside against perceived risks arising from the factored receivables, a classic example being lack of adequate credit insurance, or accounting discrepancies in the reconciliation of the factored receivables.
Borrowers should seek to minimise any ‘open-ended’ provisions permitting the bank to make reserves at its sole discretion; the permitted situations for taking special reserves should be restricted to an exhaustive list of items that the bank & borrower can quantify.
Mitigant: Credit insurance is a very good example – banks may lend against a percentage of uninsured receivables, but as this is discretionary, it’s worth the effort go over all credit insurance limits in detail making sure they are adequate for the levels of activity anticipated with the factored customers.  Similarly, where customers are refused insurance, they should be considered for exclusion from the factoring as many contracts may charge commission on any transferred receivables, even if not ultimately funded.

Note that most of the principles explained above are also applicable to other similar financing arrangements such as Asset Backed Lending where maximisation of a collateralised “Borrowing Base” is desired by the borrow

Segregation Issues

Huge reconciliation and withholding issues can occur when factored receivables continue to pay into non-factored (and unpledged) bank accounts that the bank does not have access to and (vice versa) non-factored customers may incorrectly pay into factored (Pledged and blocked) bank accounts, thus blocking the flow of free cash to the borrower.  Close attention must be paid to the identification of customers as factored and non-factored in the Accounts Payable / ERP systems of the borrower, and cash application staff need to be trained in managing cash flowing into two separate environments and to spot and fix errors quickly when they occur.

IT Programming Issues

This in itself is a huge subject; briefly, getting the IT solution right depends not only on following any IT file specifications obtained from the bank, but also on extensive testing and (because IT staff are not necessarily familiar with the borrowers’ commercial processes), the whole AR process from Invoice selection through to cash application needs to be jointly examined in detail between IT, Treasury and AP staff with respect to changes needed for implication of a factoring programme.  It is vital to identify all internal programming or process changes that need to be made to ensure accurate data is provided to the bank. Incorrect IT files or processes can lead to very costly build-up of unreconciled items, and to possible discretionary cash withholding by the bank which requires a very clean set of data files to maintain efficient factoring schemes, and borrowing efficiency.

Active Management

In addition to areas such as overdues and credit insurance, the ‘active’ management of other areas of a factoring scheme is critical to avoid costly mistakes leading to unexpected withholding of loan flows.  Borrowers should become familiar with all available reports available from the bank, and build specific metrics and reconciliation tools to make sure that what is being reported by the bank reflects what the borrower thinks should be happening in his internal AR ledger.  A Treasury team member should be given responsibility for monitoring all factoring activity, measuring the actual v assumed loan advance rates when receivables files are loaded and loan advances issued; snags are inevitable in large factoring projects, the aim should be to identify and fix issues before they are allowed to build up for several months and suddenly the bank announces that it is to withhold additional percentages of the assigned receivables.

Credit Insurance

If the particular factoring agreement requires 100% credit insurance before funds will be advanced then it is a fairly straightforward task to know what limits are available on individual buyers and to monitor them against actual sales activity and AR ledger balances.  However, some schemes do not require mandatory insurance and will even advance 100% of eligible funds against uninsured debtors; in this case, the borrower needs to keep accurate records of uninsured buyers and their current status in the factoring, with the aim of obtaining credit insurance if possible to remove any discretionary lending risk.  Also for multinational schemes, the local law around assignment of receivables can make insurance mandatory (e.g. Germany) and will lead to exclusion of certain receivables even if the overall programme does not have mandatory credit insurance requirement.

Major factoring programmes are a significant commercial undertaking and this article can only illustrate some of the key areas to be addressed when going into factoring; however the underlying message is that borrowers should never under-estimate the time, care and effort and implementation cost necessary to make the factoring results successful and that this is not something that automatically happens because an agreement has been signed.

Colin Evans