**What Is Factoring?**

# **WHAT IS FACTORING?**

Around the world, factoring is the dominant form of asset-based finance and an important source of external financing for corporations and small and medium-size enterprises (SMEs). Under assetbased finance the credit provided by a lender is explicitly linked on a formula basis to the value of a borrower’s underlying (working capital) assets, not the borrower’s overall creditworthiness. This explicit link is continuously managed so that the value of the underlying assets always exceeds the amount of the credit. In factoring the underlying assets are the borrower’s accounts receivable—that is, sale payments due from customers—which the factor (lender) purchases at a discount. For example, a seller (borrower) might receive from a factor 70 percent of the value of an account receivable, and the remaining 30 percent (less interest and service fees) upon receiving payment from the customer.<sup>1</sup> In developing countries factoring offers several advantages over other types of lending. First, factoring may be particularly useful in countries with weak secured lending laws, inefficient bankruptcy systems, and imperfect records of upholding seniority claims, because factored receivables are not part of the estate of a bankrupt SME. Second, in a factoring relationship the credit is primarily based on quality of the underlying accounts—not the quality of the borrower. Thus factoring may be especially attractive to high-risk SMEs. Factoring can mitigate the problem of borrowers’ informational opacity in business environments with weak information infrastructures if factors can develop proprietary databases on account payment performance and if the underlying accounts are the obligations of relatively transparent firms. The latter condition holds when a borrowing SME has receivables from larger enterprises or has foreign receivables from firms in countries with a stronger information infrastructure.

Occurring around the world, the global volume of factoring reached 760 billion euro in 2003, an increase of 67 percent over 1998 (Table 1A). In some countries, such as the United States, factoring’s importance as a primary source of working capital is concentrated in certain industries. But in other countries, such as Italy, factoring’s importance as a primary source of working capital is far more widespread. Both domestic and international factoring are becoming major sources of financing in developing economies—including in Eastern Europe (EU 8 plus Romania), where factoring grew by 434 percent in aggregate between 1998 and 2003, with some individual countries displaying even higher growth rates (Table 1B).

Like traditional commercial lending, factoring provides SMEs with working capital. But factoring and asset-based lending (another type of asset-based finance) are both quite different from traditional commercial lending, where credit is primarily based on the borrower’s creditworthiness rather than the value of the borrower’s underlying assets. In a traditional lending relationship in well-developed financial markets, the lender looks to collateral only as a secondary source of repayment. The primary source of repayment is the borrower and its viability as an ongoing concern.

In addition, in a traditional commercial loan the extension of credit—even when it is collateralized by accounts receivable—is not explicitly linked to the value of the underlying assets (such as the continuously updated value of accounts receivable). In contrast, under asset-based finance the under-

> 1 The other type of asset-based finance, known as asset-based lending, is practiced in only a few countries—mainly the United States, and to a lesser extent Australia, Canada and the United Kingdom. (In the United Kingdom asset-based lending is known as invoice discounting.) Whereas under factoring the lender (factor) purchases accounts receivable from the seller, under asset-based lending the lender secures the assets as collateral. Moreover, collateral is not limited to accounts receivable: it can also include inventory and equipment. Thus, asset-based lending requires good secured lending laws, electronic collateral registries, and quick and efficient judicial systems, which are often unavailable in developing countries. Asset-based lending is discussed in greater detail later in this paper.

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**THE WORLD BANK**