**What Is Factoring?**

# **Box 1. The History of Factoring**

Factoring is one of the oldest forms of commercial finance. Some scholars trace its origins to the Roman Empire (Rutberg 1994)– -and some even further back to the Hammurabi, four thousand years ago (Papadimitriou, Phillips, and Wray 1994). The term _factor_ comes from the Latin verb _facio_ , which means “he who does things.” As the Latin verb suggests, the history of factoring is the history of agents doing things for others.

For example, factoring was a well-developed activity in England in the 14<sup>th</sup> century, where it evolved with the growth of the wool industry. The job of factors centered on their functions as sales agents, or commission merchants, for textile mills. The distances between customers and manufacturers made commerce problematic—given the primitive forms of transportation and communication—so factors assumed complementary functions to address the business challenges that arose because of these distances.

At the center of these functions was the factors’ role as the sales force for the textile mills. As a byproduct of this activity, factors assumed other marketing and distribution functions, including offering advice on customer tastes, product demand, and warehousing services– -so that mills could ship merchandise to the factors, who would then ship to the final customers.

Factors also assumed some critical financial functions on behalf of the mills. They offered credit advice on how much to sell on account to potential customers. They also guaranteed payments to the mills, assuming full responsibility for the creditworthiness of the mills’ customers. To protect themselves, factors established reserves to cover claims for defective merchandise and any disputes that arose out of those claims. Finally, and equally important from an historical perspective, factors advanced funding to the mills based on the value of the merchandise sold. Thus, in essence, factoring was fully reflected economically in the financial component of the factoring business as it existed 600 years ago.

The difference between today and 600 years ago is that the sales, or “agenting,” component has been purged from the factoring relationship. But factoring as it is typically practiced in both developed and developing economies can still be viewed as a bundle of activities. In addition to financing, factors typically provide their clients with two other services: credit and collections.

A factor may enjoy several important advantages in offering credit and collection services. First, it may reap significant economies of scale in both activities relative to its clients. Because the factor performs these services for many different clients, it can amortize the fixed costs associated with them. In addition, most small SMEs likely have little expertise in either area. Finally, factors generate proprietary databases on account payment performance. The largest and more experienced factors essentially become the equivalent of large credit information exchanges, offering an alternative to private commercial credit bureaus and public credit registries. They also enjoy the same economies of scale in information exchange that credit bureaus and public credit registries do (Kallberg and Udell 2003a).

Another feature of the factoring relationship is that a factor typically advances less than 100 percent of the face value of the receivable even though it takes ownership of the entire receivable. The difference between this advance amount and the invoice amount (adjusted for any netting effects such as sales rebates) creates a reserve held by the factor. This reserve will be used to cover any deficiencies in the payment of the related invoice related to customer claims or allowances.<sup>7</sup> If and when the invoice is paid in full, the factor remits the reserve amount to the client.<sup>8</sup> A typical advance rate might be 70 percent (although this could be up to 90 percent), which establishes a 30 percent reserve.

Factors charge their clients a commission fee, and an additional interest charge (if the client avails himself of the funding option). In the simplest arrangements this could all be subsumed in a single commission. Thus, for example, if the factor purchases a $100 receivable from its client under

> 7 The availability of this reserve to cover deficiencies may vary. In the situation described above, the reserve is applied only to the invoices of a specific account. Alternatively, the factoring contract could permit reserves against one account to be applied to deficiencies in other accounts.

> 8 The reserve account represents a liability of the factor to its client. In effect, the client has extended contingent credit to the factor, exposing the client to risk. If the factor becomes insolvent, the client will become a general creditor of the factor and be exposed to a potential loss up to the amount of the reserve. Thus the factor’s reputation and creditworthiness may be important considerations for the client.

**5**

**THE WORLD BANK**