How to Successfully Manage Risks in Factoring?

In the realm of finance, risk is an inevitable companion. This reality is particularly evident in the sphere of financing through the sale of commercial receivables, commonly known as factoring. There are two main types: non-recourse and recourse factoring. In this article, we will delve into recourse factoring and the risks associated with this prevalent form of factoring in Slovenia.

Understanding Credit Risk in Recourse Factoring

Credit risk represents the likelihood that a debtor will fail or refuse to meet their obligations within the agreed time frame. This non-payment can be caused by temporary illiquidity, leading to payment delays, or insolvency, indicating a complete inability to fulfill financial obligations and thus posing a higher risk of loss to the lender. Factoring companies, acting as lenders, meticulously assess the payment ability of debtors and evaluate the financial standing of both the debtor and the seller of the receivables. Continuous credit analyses are conducted, examining various financial indicators, gathering information about the companies, scrutinizing market conditions, and even evaluating the relationships between the assignor and the debtor. Using this credit assessment, the factor determines the credit rating of the receivable, sets the limit for the receivable's sale, establishes the deal's security measures, and decides on the reserve of funds for the transaction. The determined credit rating (based on the debtor's and seller's credit assessments) is a pivotal factor in determining the interest rate or discount rate for the receivables purchase.

When is Factoring Used, and What Are the Risks?

Factoring serves as a convenient financing method for healthy and growing businesses. By leveraging factoring, companies shorten their customers' payment periods, thereby enhancing liquidity. Factoring proves especially useful for companies at the end of the fiscal year, allowing them to optimise their annual balance sheets by converting receivables into cash. This process improves the company's credit rating, which is crucial, especially when planning significant loans from banks. Another reason for selling receivables is the early settlement of suppliers' payments. Companies utilise the funds obtained through factoring for early payments via cash discounts, which usually exceed the costs of factoring. The earned funds represent invaluable revenue for the company on an annual basis, optimizing the company's resource utilization.

However, not all companies opting for factoring are financially stable. Many companies facing a significant likelihood of being unable to meet their obligations often seek factoring services. Such companies are undesirable for factoring firms, which must prepare adequately, detect such companies promptly, and reject any dealings with them. Companies that do not meet the requirements for concluding factoring agreements or obtaining financing through receivables assignment are relatively easy to identify. Preventive actions to prevent misuse necessitate additional measures from the factor.

Frauds in Factoring

Frauds and business scams are pervasive issues in the global business landscape. A 2018 study by PwC (PricewaterhouseCoopers) indicated an increase in the percentage of companies that experienced fraud or fell victim to economic crime in the past two years. Factoring companies, as providers, are particularly attractive targets for fraudsters. Consequently, they have had to develop effective and dynamic systems to recognise and promptly eliminate attempted fraud.

7 Most Common Frauds and Risks in Factoring

In the realm of factoring, where businesses seek financial solutions, there exist inherent risks and potential frauds that necessitate vigilant management. Recognizing and mitigating these risks is fundamental to the successful operation of a factoring company. Below are the seven most prevalent frauds and risks in factoring, alongside preventive measures implemented by Invoice Exchange, Slovenia's pioneering peer-to-peer financing platform.

1. Fictitious Invoices:

Factoring clients submit fictitious or duplicated invoices, attempting to defraud the factor. This risk intensifies in recurring transactions and silent assignments, where the assigned receivables are not verified with the debtor.

2. Multiple Assignments of the Same Invoice:

Factoring clients attempt to sell the same receivable to multiple factors. This deception occurs primarily in silent assignments, where the debtor is unaware of the transaction.

3. Offsetting Assigned Invoices:

Clients unlawfully offset assigned receivables instead of paying the factor, violating contractual agreements.

4. Invoices issued before the completion of the underlying transaction (delivery of goods or services)

This fraud occurs in the case of silent assignment; the debtor would not typically acknowledge such assignment, unless they are involved in the fraud themselves and intend to dispute the claim later.

5. Direct Payments to Suppliers Instead of the Factor:

Debtors pay the client directly instead of the factoring company, leading to complications during debt recovery.

6. Reduction of Invoice Amounts Due to Debtor's Credit Notes:

Debtors issue credit notes, reducing the invoice amounts. While not always fraudulent, this practice requires careful scrutiny, especially in industries where returned goods are common.

7. Subsequent Dispute of Invoices by the Debtor:

Debtors dispute assigned invoices after initially accepting the transaction, creating challenges in recovery. These disputes might not always indicate fraud but can signal conflicts between the supplier and the debtor.

Frauds in factoring can result in criminal activities and are dealt with under criminal law. Despite numerous preventive measures, factoring companies can never entirely eliminate the risk of fraud or non-payment of assigned receivables during the purchase of receivables. Sometimes, fraudulent activities are not premeditated at the time of the transaction but are initiated later due to various factors.

Additionally, there are 11 red flags that should trigger caution:

1. The person who manages the company and represents it does not have official authorisation.
2. Evidently forged business documentation and inconsistent information.
3. A partner or representative of the company has declared personal bankruptcy or had their previous businesses end in bankruptcy.
4. A partner's share is encumbered, and there is a prohibition on disposing (by court order).
5. A history of unsuccessful legal proceedings against a partner and their company.
6. Partners with a history of so-called "empty" bankruptcies, where assets were transferred before bankruptcy, preventing creditors from being paid.
7. Frequent bank account blocks and tax arrears.
8. A rich history of legal proceedings (enforcement, lawsuits).
9. Delays in providing the necessary documentation, required information, confirmation of the assignment, etc.
10. A connection between the assignor and the debtor.
11. Assignor and debtor blaming each other in the recovery process.

To mitigate these risks, the Invoice Exchange has implemented a comprehensive risk management system in collaboration with Dun & Bradstreet, ensuring real-time credit risk assessment and monitoring. The platform employs a set of 12 measures to control risks effectively.

12 Risk Management Measures on the Receivables Exchange:

1. Determination and verification of eligibility criteria for membership on the Invoice Exchange.
2. Customer review process, including verifying the identity of the customer, its legal representatives, authorised individuals, and UBOs, in accordance with the provisions of Prevention of Money Laundering and Terrorist Financing Act.
3. Determination and verification of conditions for the sale of receivables.
4. Establishment and implementation of sales limits for sellers of receivables.
5. Implementation of additional measures related to silent assignment of receivables.
6. Determination and verification of conditions for debtor receivables.
7. Establishment and implementation of trading limits for debtor accounts.
8. Verification of eligibility criteria for receivables listing.
9. Calculation of credit ratings for receivables.
10. Manual review and confirmation of exchange transactions.
11. Fractionating receivables into smaller parts to ensure higher investor diversification.
12. Conducting receivables recovery procedures.

Risk management in factoring companies undoubtedly constitutes their core activity. The success of a factoring company's operations largely depends on its risk management system, as well as the efficiency and execution of its internal procedures.