Recourse in Factoring

Recourse in Factoring Meaning

Recourse is a type of Factoring which happens when an entity has to sell the invoices to the client (factor) with a condition that the entity will purchase back any invoices that remains uncollected, this means that in recourse, the factor (client) is not taking any risk of the uncollected invoices.

In simple words, it is the selling of account receivables by a company to a factor at a discount. The factor pays a percentage of the account receivable to the company, and later, after collection of the total amount from the debtor passes the balance amount (net of the discount) to the company.

Recourse in-Factoring

Example of Recourse in Factoring

Suppose Company A is selling $100 worth of goods to Company B on 1st May, who is to pay back on 31st May. Now Company A sends the invoice copy to the Factoring Company, who sends $80 to Company A. On 31st May, the Factoring company collects $100 from Company B and transfers the balance (100-80-5 = 15) $15 to Company after keeping $5 as factoring fees.

Example

Let us get into the details of the two major types – recourse and nonrecourse factoring.

In this, the seller has to pay back the factor in case of non-payment by the debtors. In other words, the seller assumes the risk of any uncollected invoices. Recourse time is the amount of time for which the Factoring company will keep the invoice open. In other words, if the customer is not paying after the recourse time has passed, the Factoring Company has the option to chargeback the entire invoice from the seller.

Let us look at an example to understand this concept.

Company A sells $1000 worth of goods to Company B, which will pay Company A back after 6 months. Company A also sends a copy of an invoice to a Factoring Company, which transfers $850 to Company A on the same day. After six months, the Factoring company collects $1000 and, after deducting a 10% commission of $100, returns the balance amount of $50 (1000-850-100=50) to Company A.

The journal entries for Company A would look like this.

Entry 1

On the other hand, in non-recourse factoring, the factor absorbs the risk of non-payment by borrowers. Since it is riskier, the transaction fees paid to the factor are higher than in recourse factoring.

For the same example explained above, if we assume factor fees to be 20% (it is generally much higher due to the high risk involved), the journal entries for Company A will look like this.

Recourse in Factoring Entry 2

Difference Between Recourse and Non-Recourse Factoring

Parameter Recourse Factoring Non-Recourse Factoring
Counterparty Risk Borne by the seller; Borne by a factoring company;
Factor Fees Low High
Advance Amount High because the risk is borne by the seller. Low because factoring company has to bear high risk.
Profile of Debtor / Borrower A credit profile has to be evaluated by the seller and is generally easy as the seller already has a relationship with its customer /borrower. Very detailed due diligence is done by the factoring company before agreeing for such accounts receivables factoring.

Advantages

  • It is a very easy way to advance money on account receivables and build up cash flows.
  • It also transfers the hassle of collecting payments from debtors to a third party so that the seller can focus on its core business.
  • It is much cheaper for the seller since factor fees are low.
  • Since the risk is not borne by the factor, recourse factoring is readily available in the market and has a faster approval.

Disadvantages

  • Since the entire risk of default is borne by the seller, the seller must perform proper due diligence of the credit profile of the customer.
  • It may heavily affect the financials of the seller if the customer defaults on a large sum.

Conclusion

Before deciding on which type of factoring to go for, companies should depend upon two main factors. Firstly if the amount of account receivable is low, the seller can afford to take the risk of non-payment and opt for recourse factoring. Also, if the seller has a good relationship with the customer and is confident about its debt repayment ability, recourse factoring is the preferred way. Finally, it is very important to define and understand the terms of the factoring agreement clearly. Even in non-recourse factoring, the Factoring Company might agree to pay only if the customer has declared bankruptcy and not if the customer is not paying or has run away with the money.

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