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 will be needed. Each customer must have an endorsed credit limit rather than a discretionary limit. In addition, this type of agreement is designed to be a whole of turnover agreement on a selected customer basis. This means that the whole of the turnover for each programme customer is offered to the factor for financing.
For the facility to fall within the scope of an off-balance sheet facility, it is necessary that the client surrenders control of the asset. In this type of facility the client does surrender the asset, although a 10% indemnity remains. This indemnity does not mean that the client retains control. However, it is a contingent liability in the client's accounts.
Why off-balance sheet?
Off-balance sheet financing is a form of financing which is kept off the company's balance sheet through various classification methods. The company often uses off-balance sheet financing to keep its debt to equity and leverage ratio low. This is especially if the inclusion of large expenditure would break negative covenants with other financiers. An off-balance sheet factoring facility is usually adopted by larger corporate entities which may have quite sophisticated funding in place, for example senior and mezzanine debt. By having the factoring facility off-balance sheet, the financing ratios will not be affected.
With this facility there is a true sale from the client to the financier of the underlying invoice. As for recourse, the use of a credit insurance policy ensures that 90% of invoices are indemnified by a third party and do not appear as a contingent liability on the balance sheet. When the uninsured 10% portion is combined with the discount charge, this resembles the rental element in a sale and lease back situation.
This method of financing provides the client with an increased working capital without affecting the covenants in the existing facility agreements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
