Off-Balance Sheet Factoring In Focus

As companies increasingly turn to the secondary market for

finance, the effective structuring of off-balance sheet factoring

facilities takes on a new level of importance.

The problem

Where a company is of a reasonable size, it is likely that there

will be existing facilities in place which contain covenants

relating to debt/equity ratios. It may not be possible for the

company simply to discount its receivables as the debt to equity

ratio may breach the covenants in senior lending agreements.

To avoid this situation, a company may try to raise working

capital by using off-balance sheet funding solutions. One example

is to discount the company's invoices through an off-balance

sheet factoring facility. In this article, we briefly examine the

mechanics and the treatment of this facility.

Explanation of the mechanics

In order for an off-balance sheet facility to be a viable

funding method for both the lender and the borrower, it must be

workable from the client's point of view and secure from the

lender's standpoint.

The first component is that the client obtains a credit

insurance policy from a major credit insurer. This is in turn

assigned to the factor. Due to the nature of the facility, this

insurance policy must cover 90% indemnification of loss. The

customer then enters into a letter of undertaking which

acknowledges its acceptance of the finance programme, including a

charge for the financing of the extended payment credit period -

usually between 60 and 180 days. The customer finance charge is in

turn added to the value of the invoice.

At the end of each month the client offers to sell to the factor

all the invoices issued during that month to the finance programme

customers. The factor will purchase all the eligible and approved

invoices and pays 100% of the value of the goods less a supplier

discount.

After this, the factor advises the programme customers of the

purchase and confirms the extended payment date. At due date, the

customers pay the factor directly the full value of the invoice,

including the value of the goods and the financing charge. The

factor has recourse to the client for 10% of the unpaid amount in

the event of any customer failing to pay ? this is due at

the time that the 90% indemnity is payable by the credit

insurer.

To further police the security of this type of agreement, strict

controls on the credit worthiness of the customer are essential. In

order to become a programme customer, a full insurance limit...