Factoring

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Related Topics:
  1. Affidavit
  2. Credit insurance
  3. Factoring
  4. Objection
  5. Foreclosure
  6. Default of payment
  7. SCHUFA
  8. Enforcement Officer
  9. Opposition
  10. Dunning notice
  11. Statute of limitations
  12. Receivable
  13. Enforceable title
  14. Debtor
  15. Creditor
Table of contents:
  1. What is factoring?
  2. How does factoring work?
  3. What types of factoring exist?
  4. What are the advantages of factoring?
  5. What are the disadvantages of factoring?
  6. What legal and contractual aspects apply to factoring?

What is factoring?

Factoring is a financial service in which companies sell their outstanding receivables to a factoring provider. Instead of waiting for their customers to pay, they receive a portion of the invoice amount upfront. The factoring provider then takes over the receivable and handles the collection process.

Depending on the type of factoring chosen, the risk of non-payment may either be assumed by the factoring provider or remain with the original creditor. Additionally, this service incurs fees that vary depending on the provider and business model. Factoring is often used as an alternative to traditional receivables management, but it can also impact customer relationships and a company's cost structure.

How does factoring work?

Factoring is a process in which companies sell their outstanding receivables to a factoring provider to access liquidity more quickly. The process can be broken down into several steps:

1. Selling the receivable

The company issues an invoice to its customer and transfers it to the factoring provider. Receivables may be sold individually or bundled at regular intervals.

2. Immediate payout

After reviewing the receivable, the factoring provider advances a large portion of the invoice amount—typically between 80% and 90%. The exact amount depends on factors such as the debtor’s creditworthiness and the agreement between the company and the factoring provider.

3. Collection of the receivable

The factoring provider assumes responsibility for managing the receivable and collects the payment directly from the debtor. In some cases, the debtor is informed about the sale of the receivable (known as disclosed factoring), while in other cases, the transaction remains undisclosed (undisclosed factoring).

4. Final payment and fees

Once the debtor has paid the invoice, the company receives the remaining balance, minus the factoring provider's fees. These fees vary depending on the provider and are influenced by factors such as transaction volume and default risk.

Depending on the type of factoring used, the risk of non-payment may be assumed by the factoring provider (recourse factoring) or remain with the original creditor (non-recourse factoring). While factoring can be a useful tool for improving liquidity, it also comes with costs and potential implications for customer relationships.

What types of factoring exist?

Factoring comes in various forms, differing in risk allocation, transparency, and operational procedures. The most common types include:

1. Recourse factoring (with default risk retention)

In recourse factoring, the factoring provider assumes full responsibility for the risk of non-payment. If the debtor fails to pay, the company remains financially secure. This option tends to be more expensive but provides greater protection.

2. Non-recourse factoring (without default risk retention)

Here, the company retains the risk of non-payment. While the factoring provider handles receivables management, it does not cover any financial losses in case of debtor default. This model usually involves lower fees, but the company remains exposed to payment risks.

3. Disclosed factoring (debtor is informed)

In disclosed factoring, the debtor is notified that the receivable has been sold. Payments are made directly to the factoring provider. While this increases transparency, it can also affect customer relationships.

4. Undisclosed factoring (debtor is unaware)

Here, the receivable sale remains hidden from the debtor. Payments are made as usual to the company, which then forwards them to the factoring provider. This approach is often used to maintain business relationships without raising concerns.

5. In-house factoring (internal receivables management)

The company remains responsible for receivables management and collections, while the factoring provider acts solely as a financial service provider.

6. Full-service factoring (comprehensive receivables management)

The factoring provider handles not only financing but also the entire debtor management process, including invoicing, dunning procedures, and collections.

The choice of factoring model depends on a company’s specific needs. While recourse factoring offers greater security, non-recourse or undisclosed factoring may be more cost-effective.

What are the advantages of factoring?

Factoring is often used as a means of quickly obtaining liquidity. However, selling receivables to a factoring provider also comes with costs and potential drawbacks. The main advantages include:

  • Faster liquidity, but with deductions:
    Companies receive part of their invoice amount upfront. However, they do not receive the full amount immediately, as factoring providers deduct fees and risk-related discounts.

  • Outsourced receivables management, but at a cost:
    Some factoring models include dunning procedures and payment collection. However, this service incurs additional costs and may affect customer relationships.

  • Potential protection against non-payment (only with recourse factoring):
    In recourse factoring, the provider assumes the risk of non-payment. While this can offer financial security, it comes with higher fees. In non-recourse factoring, the company remains liable for payment failures.

  • Better financial planning, but at the expense of profit margins:
    Receiving early payments allows businesses to manage liquidity more predictably. However, factoring reduces profit margins due to associated fees, and companies may not receive the full invoice amount.

While factoring can provide short-term relief, it also involves costs and contractual obligations. Businesses should carefully evaluate whether this financing method is beneficial in the long run.

What are the disadvantages of factoring?

Although factoring can help improve cash flow, it also comes with several downsides. Companies should carefully assess whether it is a suitable long-term solution:

1. High costs and fees

Factoring providers charge fees based on receivable amounts, debtor creditworthiness, and risk factors. These costs can significantly impact profit margins, making factoring expensive over time.

2. Not all invoices are accepted

Factoring providers do not accept all receivables. Invoices with long payment terms, high default risks, or lower amounts may be rejected, making factoring an unreliable financing method for some businesses.

3. Partial payout of receivables

Typically, only a portion of the invoice amount (e.g., 80–90%) is paid upfront. The remainder is disbursed only after the debtor pays—minus additional fees.

4. Impact on customer relationships

In disclosed factoring, customers may react negatively to the sale of their receivables. Some may perceive it as a sign of financial instability or feel pressured by the factoring provider’s collection process.

5. Contractual commitment and dependency

Many factoring agreements involve long-term contracts with minimum transaction volumes. This can create dependency, even if factoring is no longer the best financial solution for the company.

6. Limitations based on factoring type

In non-recourse factoring, companies remain liable for unpaid invoices despite paying factoring fees. Recourse factoring tends to be more expensive. Additionally, providers may impose restrictions on which receivables qualify for factoring.

Whether factoring is a viable solution depends on the company’s specific circumstances. Businesses should carefully weigh the costs and risks against the short-term liquidity benefits.

Factoring is subject to specific legal and contractual regulations in Germany. Companies should ensure they meet the relevant legal requirements before opting for factoring.

  • Factoring as a regulated financial service:
    Factoring is classified as a financial service under the German Banking Act (KWG) and requires approval from the German Federal Financial Supervisory Authority (BaFin) (§ 1 Abs. 1a Satz 2 Nr. 9 KWG).

  • Assignment restrictions in contracts:
    Under § 399 of the German Civil Code (BGB), receivables may not be assigned if contractually prohibited. Such clauses are common in supplier and service agreements. However, assignment bans in standard business terms (AGB) for consumers are legally invalid (§ 308 Nr. 9 BGB).

  • Limitations in the B2C sector:
    Factoring is mainly used in B2B transactions, as consumer protection laws impose stricter regulations on receivable transfers. Some factoring providers exclude transactions involving private individuals.

  • Mandatory disclosure requirements:
    Depending on the factoring model, debtors may need to be informed about the receivable transfer. While disclosure is mandatory in disclosed factoring, some contracts or industries may require transparency even in undisclosed arrangements.

  • Tax and accounting implications:
    Factoring affects financial reporting and tax obligations. Companies should ensure they correctly account for factoring transactions in their financial statements. Depending on the model, factoring can impact equity ratios.