The two types of factoring used when using invoice discounting or invoice factoring are recourse vs non-recourse.
Since the borrower’s invoices have already been issued, the provider already has a reasonably good chance of recouping their debt.
The lender will still assume a level of risk. Factors will usually add in a clause to the contract or borrowing indicating the term recourse or non recourse.
Companies decide to factor their accounts receivable for a number of reasons. Business owners at this point will choose which type of factoring they will require to undertake.
What is Recourse and non Recourse Factoring?
Recourse vs. Non-Recourse Factoring: What’s the Difference? When it comes to funding their businesses, many entrepreneurs turn to invoice factoring. Invoice factoring is a type of financing in which a business sells its accounts receivable (invoices) to a third-party lender at a discount. The lender then collects payment from the customer on behalf of the business. There are two main types of invoice factoring: recourse and non-recourse. So, what’s the difference between the two?
With recourse factoring, the business is responsible for collecting payment from the customer if the customer does not pay the invoice within the agreed-upon time frame. This means that if the customer defaulted on payment, the business would be on the hook for paying back the loan to the lender. Non-recourse factoring, on the other hand, protects businesses from this risk. If the customer does not pay the invoice, it is up to the lender to collect payment – not the business. This type of factoring is often more expensive than recourse factoring, but it can be worth it for businesses that are worried about non-paying customers.
Once you’ve decided which type of debt finance is right for your business, you’ll need to choose between an agreement with recourse, or a non-recourse arrangement. So let’s take a look at each of these options so you have a better idea of which one you should choose.
Recourse Factoring
Recourse factoring means that you remain liable for debts not paid by your customers. If the lender is unable to collect payment, you’ll be required to refund the cash advance for that particular invoice.
You may find that recourse factoring is cheaper than the alternative, but this is because you are taking on all the risk. Additionally, a factoring agreement with recourse usually means that a higher percentage of each invoice is made available because the lender knows they can legally reclaim the money if necessary.
Whether or not you have the appetite for this risk depends on the past payment history of your customer base. If you are confident that customers will pay in the main, then factoring with recourse could be the best option.
Non Recourse Factoring
Non recourse factoring means that a lender is responsible and takes on full liability for non-payment of your customers’ debts. This arrangement would be suitable if there is an element of doubt about their ability to pay, either now or in the future.
The terms of a non recourse invoice finance agreement incorporate the additional risk taken on by the lender. These include higher fees and a lower cash amount advanced, so you wouldn’t have immediate access to as much cash.
Additionally, genuine dispute or query with an invoice, then the terms of a non recourse agreement would not cover it.
Advantages and disadvantages of non-recourse factoring
There are a number of advantages and disadvantages of non-recourse factoring, these include:
Advantages of non-recourse factoring:
Credit insurance – Non-Recourse credit insurance is available to help cover and recoup costs should your client not pay your invoice, and it gets recourse back to you by the lender.
Free credit check– Non-recourse factoring offers free credit checks on your customers, this will ensure that they are credit worth and give a credit limited on what you can allow them on a monthly basis.
Cost effective – Non recourse factoring offers a cost effective solution way of outsourcing your sales ledger while freeing up your time to manage the business.
No security required – With this type of factoring there is no security is required with non recourse, so your business assets are safe.
Disadvantages of non- recourse factoring:
Risk – You will be responsible to repay the lender the money they lent you if your customer does not pay the invoice or you have no credit insurance.
Customers – Some customer may not be happy you are using a third party factor to fund your invoices and wish to deal with you directly.
Cost – as you are using a finance facility there is a cost so this means a reduction in your profit margin.
Offer a lower credit limit – The factoring company’s trade credit insurance, will look to offer them protection by placing limitations on factoring credit limit line size.
What is the Risk for Non-Recourse Factors?
The risk for non-recourse factors is that they lend money without stipulating that the lender should retain responsibility is that of fraud. For most factors, fraud represents their single business risk so they take considerable time to research a company’s clients before lending money. Within the factoring industry this type of fraud is known as ‘Fresh air invoicing‘
Due to the risk, non-recourse factoring comes at a higher cost to the borrower. Some borrowers remain happy to assume this cost, however, because the costs of non-recourse factoring are usually lower than credit insurance, a notoriously expensive business. Borrowing money from a non-recourse factor is, therefore, akin to complete peace of mind for the borrower because, should the invoices not be paid, they cannot be held responsible.
Read more: How are factoring companies regulated?
Conclusion
In conclusion, the decision between recourse and non-recourse factoring depends on various factors, including the level of risk tolerance, financial stability, and cash flow management goals of a business. Recourse factoring offers more flexibility and potentially lower costs, as the business assumes the risk of non-payment by the customers.
On the other hand, non-recourse factoring provides a higher level of protection, as the factoring company assumes the risk of customer non-payment. It may come with higher fees and stricter eligibility requirements.
Ultimately, businesses should carefully evaluate their unique circumstances and weigh the pros and cons of recourse and non-recourse factoring to determine the best fit for their specific needs and financial situation. Consulting with a financial professional or factoring company can provide valuable insights and guidance in making an informed decision.
Seasoned professional with a strong passion for the world of business finance. With over twenty years of dedicated experience in the field, my journey into the world of business finance began with a relentless curiosity for understanding the intricate workings of financial systems.