Chapter 7: Factoring and Reverse Factoring

Insights Book | 20 September 2024

Trade finance can be split into two broad groups: the high- quantity/low-value transactions with standard templates and highly automated processes, and the tailored transactions in our sector that require personal attention to undertake the individual business necessities.

Standard agreements are cost and time saving for bulk transactions. We are in the business of crafting individual agreements that support the borrower in the areas they need most. Our work is to ensure that every client and customer receives the best solution available, by providing a financial concierge service. This offers a thorough analysis of the specific business requirements to be matched with the most suitable type of agreement.

In the early stages, particularly of an international business relationship, there can be much apprehension by exporters working with new importers. Exporters can never really be sure that importers will pay their invoice on time or at all.

Factoring and reverse factoring differ fundamentally from supply-chain financing. In factoring, shareholders are investing in – buying – a credit-insured invoice as opposed to investing directly into the value chain. Buying credit-insured discounted invoices from SMEs is a cost-effective and straightforward way to finance SMEs in a secure way, bridging a lack of working capital or equity. A seller is now in the position to finance a larger shipment of cargo while still serving its current clients without any gaps in service or product supply.

Compared to supply-chain financing, factoring is a more streamlined process with fewer moving parts, people or documents. An invoice can be factored at any stage, from the pre-shipment process until after the product has already been delivered to the importer. Some companies factor invoices on ‘future sales’ where the buyer has yet not been identified. This is a type of risk that does not fit our business philosophy. Once the factor has purchased an invoice or a portfolio of invoices regardless of credit insurance, and the specific parameters of the contract have been laid out, the exporter signs a sales/purchase contract with a factor including a discount.

The buyer pays the full invoice amount to Artis on the date due, regardless of when the goods are bound to be received. The arrangement is convenient for the sellers and the factor receives their margin for providing the funding. Buying the existing invoice minus the discount from the exporter locks in the margin upfront.

A factor is connected to in-depth financial and business information, including business databases, credit ratings or credit insurance that a seller often does not subscribe to or wish to pay for. For us it is money well spent.

Credit-insured invoices offer a high degree of protection against a buyer’s inability or unwillingness to pay. While, ideally, sellers would have trade insurance on their buyers, not all sellers wish to purchase it. When an importer fails to pay, there is no formal protection for exporters and local sellers to recover their losses. The seller might have to go to a court in their own country or in a foreign jurisdiction, which might require dealing with the matter in a foreign language. With factoring, SMEs have guaranteed cash flow.

Another reason SMEs use factoring is to finance their growth. Growth financing can be a blessing and a curse as with the expansion of the company, not only does the invoice volume start to grow, but the raw-material-purchase bills to manufacture more goods grow as well. Rapidly growing companies may find themselves with more orders than inventory due to financial restraints. This is especially true when exporters’ funds are tied up in late or slow-paying receivables.

A small steel manufacturer with low margins might require the buyer’s cash to purchase the raw material to produce the product ordered. This can be a dicey part of the value-chain financing. When sellers can’t service the needs of their customers, they might lose the business. The solution for manufacturers, provided they have the cash flow, is to pre-pay their suppliers for the additional raw material or parts to promptly fulfil all orders, thus, keeping their loyal customers and providing inventory for the new ones.

While factoring is more straightforward than supply-chain financing, it still requires a healthy amount of risk mitigation and due diligence. The first step in the factoring process is the verification of parties’ details. Factoring financiers wish to ensure that the seller requesting financing is in a legitimate business. The verification stage includes background checks, and company-history and overall reputation checks, as well as looking into the credibility of the importer.

Financial Review and Background Check

Financial reviews and background checks are critical steps in the process of authenticating an investment applicant. By thoroughly reviewing an enterprise’s financial history and annual reports and completing a background check on the major players involved, a factor can rest assured that the applicant isn’t trying to deceive and will be able to repay the investment. Before an agreement is signed, Artis verifies the value of the product being factored.

Once the sellers and buyers are both verified, it is time for personal due diligence. Artis project managers take trips to visit the company on-site to perform the audit. We look at the entire business process from production to shipment (ship, truck and plane). Investment firms invest large sums in purchasing invoices and it is the financiers’ concern that the company will consistently deliver what the buyer has ordered from the importer, thus avoiding product issues upon arrival.

Artis reviews contracts in person and on-site. This minimises risks and misunderstandings when it comes to the factoring arrangement. Artis walks the exporter through the agreement in detail, giving the seller time to ask questions, address concerns or clarify. The parties must understand and agree to what is expected from each other in the transaction.

Once the exporter signs off on the contract, Artis owns the invoice of that shipment. Before the exporter is paid, Artis visits them. The buyer/importer is audited as well in a similar process.

A contact person from the importer is identified to address any issues with Artis during the process and until payment has been completed. The KYC process we discussed earlier verifies that the customers are who they claim to be.

Once the payment is made to the exporter, the agreement is set in motion. The invoice and any credit and fraud insurance covers are transferred to the funder, who will monitor the deliverable and the payment terms agreed with the buyer. We prefer repeat business to one-off shipments, as the costs of setting up the relationship can be amortised over various deliveries. Artis tries to keep the tenors short, up to 120 days. The more quickly the product turns over, the sooner the parties get paid, and the more product can be shipped.

Factoring helps SMEs manage their customer’s credit and their cash flow. When an SME factors an invoice, the buyer owes that money to the investor and no longer to the seller. However, instead of the importer having a debt listed on their balance sheet’s financial records, the invoice shows up in their account off balance sheet under ‘trade payable’ or ‘accounts payable’, which can protect a credit score rather than reflecting excessive debt on their financial record, if they pay their shipments on time.

It very much remains an obligation for the company, though, and analysts do also look at off-balance-sheet obligations. In factoring and reverse factoring, the credit line can be adjusted to the buyer’s needs, provided their financials can support the increase of sales.

In a time of economic mayhem or decay, financial flexibility is a strong financial lifeline for a company. We saw businesses who typically paid their invoice tenor early or on time requesting payment extensions when the Covid-19 pandemic hit. The use of short-term factoring keeps thousands of businesses alive during economic hardships.

Factoring does not require the SME shareholders to give up any shares in their company or to sell or raise equity. Instead, it provides the factor ownership of a particular invoice only. The mission of a factoring company is neither to become a shareholder nor to run the company. The mission is only to improve the cash- flow situation of the company through factoring.

Reverse Factoring

Reverse factoring is initiated by the importer/buyer. It is best applied with solid, A-rated customers. Reverse factoring is not recommended in cases where the customer’s credit quality is low-grade, or the proceeds are used to stretch deficient working capital.

Buyers favour reverse factoring to reduce the risk of supply- chain disruption. When importers have access to early payments, they are in a better position to honour their purchase due to the higher capital received upfront. With the funds transferred to the exporters on behalf of the importers, the exporter is keen to ship the cargo, reducing stock and freeing up space in the warehouse and cash. At the same time, buyers can grow their customer network without the added concern of a liquidity squeeze. Importers can sell the product in the market often before the invoice is due.

Reverse factoring increases the available working capital to importers. More working capital means that importers can increase the days payable outstanding (DPO). DPO is the average number of days it takes for a company to pay its suppliers and is a benchmark for investor and financing companies to determine the creditworthiness of a business.

A higher DPO indicates that a company takes longer to pay its suppliers. At least on paper, the company looks riskier. Especially during a growth phase, companies want to achieve a low DPO ratio, to remain attractive for new investors, proving legitimacy and reliability as a commercial party.

More working capital combined with a low DPO figure puts importers in a better position to negotiate with exporters. Importers who offer their exporters reverse factoring might negotiate more favourable commercial terms with their suppliers and get better trade deals and rates.

Factoring and Reverse Factoring

The process for reverse factoring follows the process for regular factoring as laid out previously. The same due diligence is done between the exporter, importer and their business connections. Once completed, the importer enters into a contractual agreement with the exporter and agrees on shipment volume and frequency. Subsequently, the exporter sends their invoice to the importer stating payment terms and conditions.

On receipt of the invoice, the importer submits the invoice to the trade-financing firm. The firm takes ownership of the invoice, including any entitlement to credit insurance, offering payment options to the importer/buyer ranging in our case up to 120 days. If the importer/buyer chooses to pay early, the finance provider will offer the importer/buyer a discount. Alternatively, the importer pays the total value of the invoice at the agreed payment date.

Walmart is a good example of a company using factoring and reverse factoring with suppliers. Becoming a Walmart vendor is a significant win for smaller exporters looking to generate more sales, hence revenue. This, however, can be a double-edged sword, as ‘giants ‘like Walmart are known for placing massive orders but only allowing small margins.

It’s the manufacturer’s volume/margin dilemma. Such large orders can strain a smaller company that might not have the capital to meet the product demands ordered by a multibillion sales company.

The Walmart brand has always vouched for bringing products at the lowest price possible to consumers. Such promise still holds to this day, with the likes of Primark and Aldi promoting similar market philosophies. Large distributors sometimes sign big contracts with smaller, reasonably priced SMEs to find the lowest price for products.

Winning a mammoth order is one thing, but now the SME needs to finance the raw material, production and shipment. While we have been referring to Walmart again as an example, this applies, of course, to any large conglomerate with large distribution, hence purchasing power.

An Example of Factoring

Artis was founded on the principles of logic, data analysis and responsibly contributing to more efficient trade in the world, however small this contribution might be in a multi-trillion-dollar market. It is not our mission to champion or judge any specific causes, but we could not ignore a use of factoring that Walmart demonstrated several years ago.

This factoring illustration is meant to serve as an example of the immense benefits of invoice factoring in the face of internationally fluctuating supply and demand.

In 2017, the FBI reported more than 25 million firearm background checks linked to gun-purchase orders − more than a four-million-person increase from the previous two years. Major manufacturers like Smith & Wesson and Sturm Ruger were seeing record sales, in addition to major American firearm retailers including Cabela’s and Dick’s Sporting Goods, but it was Walmart who was leading the charge.

Walmart, a multibillion-dollar corporation, had one of the most significant years of firearm sales on record and the market continued to surge. In 2017, Walmart decided to apply reverse factoring. Large retailers around the world pay their invoices on open-account terms, requiring up to 60 days before remitting payment for the products sold. Why? Probably because they can. They place substantial orders. Take for example the food industry. If it takes two months for manufacturing and shipping, it could take up to 120 days before the manufacturer would receive a payment.

In our firearm case, Walmart did not want to advance the cash to manufacturers to finance their raw-material purchases. Instead, it sought reverse-factoring arrangements with an independent factor. The factor provided capital to the gun manufacturers to expand their production capabilities and keep up with the growing firearm demand.

Depending on the market’s competitiveness, large international manufacturers can negotiate reverse factoring for as little as one to two percent of their margin over the standard rate. In smaller markets or for smaller companies, the cost can be one to two percent per month.

In Switzerland the market is currently at two per cent for 60 days of factoring in Brazil and other countries 1.5- two percent per month. This is hard to understand in times of low or negative interest rates. Swiss banks currently charge up to three percent per annum for money deposited.

This arrangement provided Walmart with time to pay the invoices and helped to ensure that its shelves were stocked with products that its consumers wanted most – and immediately. Once a consumer decides on a purchase, they do not want to wait – and the seller knows the psychology of its buyer.

As with all the other types of financing, there is also inherent risk with factoring and reverse factoring. Transport and damaged goods are a risk but not a fault of the exporter and are generally insured by a transport insurance.

The timeliness for a delivery of products is of particular concern when the product is part of a just-in-time supply chain. A delay of just one day can mean stock and supply-chain disruption. Manufacturers and buyers depend on the punctual flow of parts in a world of lean supply chain with little stock in storage.

Timing and preparation for perishable deliveries are essential elements of a logistics and investment firm’s verification and optimisation process. Then there is the risk of wrong delivery or non-delivery. It can take weeks for a shipment to be returned, especially in international trade, and another delivery is deployed to the importer. Importers are losing out on sales due to a delay and the tenor needs to be extended as importers might not have generated enough sales to satisfy the invoice.

A Practical Case of Non-Payment

The possibility of not receiving payment is what keeps business owners, especially those of SMEs, awake at night. If the factor doesn’t stay in touch with the importer, some rare importer may be tempted to ‘forget’ to remit payment. After all, the exporter has been paid, and the importer received their goods. It is easy to ignore a faceless financier, particularly in a faraway country. To avoid such ‘amnesia’ we keep a close, face-to-face relationship with the businesses we are working with, for sellers and buyers to establish a personal partnership with our firm.

A new business that emerges in a market with competitive pricing can put pressure on profit margins for the current importer in pole position. When an industry or a market gains a new enterprise, the established companies must defend their market share. Many new enterprises will initially offer their product at unsustainable discounts, attracting a host of price- curious customers, a practice which is illegal. A factor’s pending invoice might run into payment issues but credit insurance will take care of this.

To compete with the new competitor on the block selling similar products at lower costs, other distributors might be forced to reduce their prices of that product line as well, unless they enjoy a privileged or monopolistic market position. Lower prices generally lead to lower margins, unless you can compensate for the loss by lowering your production cost, which in turn would mean inefficiency in the production process to start with. Necessity is the mother of all invention.

We, like others, apply a thorough credit assessment to mitigate internal and external credit risks. We do credit screening to confirm that the business has properly operated for at least two years. We want to see and understand a clearly defined purpose for the factoring need and ensure that our agreements are specific, clear and straightforward. The internal credit screening process ensures that the SME being financed can meet a minimum product turnover threshold. Does the company have a network of distributors to support that minimum product turnover? Do they have the suppliers to support the demand?

The internal credit screening takes a very detailed look at the creditworthiness of an SME, leaving no stone unturned. While we don’t work from credit scores alone, we investigate whether a company is well-rounded, meets its projected goals and conducts reliable business within its industry and commercial networks.

In the effort to reduce fraud and money-laundering risks associated with factoring in international transactions, we execute a qualitative and quantitative risk analysis on the key owner(s) and senior managers.The current commercial value of the collateral needs to be checked, as it affects the quality of the debtors, suppliers and their financials. Old, obsolete stock and perished goods are worth much less over time than the initial purchase price. The internal credit check tests the recoverability in case an asset is completely lost.

Finally, all bank statements are reviewed by Artis’ risk- management team, verifying the cash flow and ensuring that a single invoice has not been double financed. After completion of all internal screenings, the information is turned over to an independent third party for validation.

Third-party companies like Allianz Trade (formerly Euler Hermes), a market leader in credit insurance and part of the leading Allianz group, and others independently verify all the documents provided by factoring and supply-chain financing companies before they confirm credit-insurance limits.

As a result, the credit-insurance company or credit agency will establish its own credit rating for the SME and assign a maximum factoring amount based on the buyer’s financial records, cash-flow receipts and sales records, limiting the risks on country and counterparty exposure. We check this information against our assessment to establish the terms of the factoring contract. A credit insurer can provide further trade-insurance options that cover bankruptcy, fraud and production errors.

Like trade financiers, credit agencies and insurers are not solely focused on exporters. Financing agreements, factoring limits and other terms are influenced by the importer’s history. We want to be assured that an exporter delivers a good product and on time. Still, the financing arrangement is based on the importer’s credit rating, not that of the exporter.

Statistically, factoring remains a very low-risk activity. Even in the face of the global pandemic that rocked the world economy, factoring remained a steady source of yield for exporters, importers and investors alike. While the rest of the world economy fluctuated almost daily amidst government shutdowns and financial strain, SMEs worldwide continued to buy and sell their products, some on a large scale. The success of online sales has been widely reported.

Grocery stores and home-improvement industries continued to boom not despite but because of the recent pandemic turbulence. Demand for cleaning supplies, toilet paper and other household goods went through the roof.

Many importers, investors and PPE opportunists did well. Factoring as an investment class is uncorrelated to the stock markets, so factoring deals also continued to thrive in the face of global economic uncertainty. Factoring has become a financial tool that businesses have leveraged to survive the recent economic turbulence, and it proves to be profitable and successful time and time again.