Factoring as a Financing Option: Evidence from the UK

Khaled Soufani
Assistant Professor
Department of Finance
Concordia University
Montreal, Quebec, H3G 1M8
Canada
Tel: (514) 848-2926
Fax: (514) 848-4500
E-Mail: Ksoufani@mercato.concordia.ca

The author would like to express many thanks to Dr. Martin Binks at the University of
Nottingham’s Business School for his comments and suggestions.

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 Factoring as a Financing: Evidence from the UK

Abstract

This paper develops and tests hypotheses that explain the choice of factoring as a
financing source and the type of businesses using it in the UK. The tests focus on
establishing a profile of borrowers, based on firm’s demographic characteristics such as
age, turnover, industry, and type of legal ownership. In addition to that we extend the
analysis to test whether there exist any association between the use of factoring and the
availability of credit to firms, the collateral requirements by banks and its value, the value
of the firm’s debt, and also whether the business is experiencing financial difficulties.
The analysis refers to a survey of 3805 companies of which 212 were using factoring
services. We find evidence that each is an important determinant in firms’ choice of
factoring as a source of finance for working capital and an instrument to cash flow
improvement but it is a financial option that is not universally available.

JEL Classification code: G32, G29

Key words: Factoring, Invoice financing, Working capital, Finance gaps

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 Factoring as A Financing Option: Evidence from the UK

1. Introduction

Small or medium size enterprises (SMEs) may face many problems and market
challenges in their efforts to develop and grow. With the many difficulties faced by the
small business sector, the unique financial problems that overshadow the barriers
hindering the small firm’s survival and growth pertain to credit rationing and finance
gaps. The notion that SMEs experience disadvantages in their relationship with the
capital market, i.e. the existence of credit rationing (Stiglitz and Weiss, 1981) and also
Finance gaps in their relationship with banking institutions (Storey 1994; Mason and
Harrison 1994; and Binks et al 1994, 1996, 1998) have been popular for decades. The
existence of this problem normally directs many businesses to seek different alternatives
of finance for their operations. As sales grow, the major initial source of external
financing is likely to be trade credits and to some extent stringently regulated bank loans.
Many small or medium sized enterprises (SMEs) may confront problems when
attempting to gain access to external funding because of the natural difficulties which
financial institutions face in producing consistently reliable risk assessment processes.
Particular problems for firms may be experienced in the management of working capital.
In an attempt to alleviate such problems many firms have sought to pledge and finance an
important element in their working capital, that of accounts receivable; a process known
as factoring. There has been a rapid growth in the use of factoring and invoice
discounting with an average annual rate of growth in excess of 20% (Factors and
Discounters Association 1998). This is estimated to contribute around 6% in additional
finance to SMEs compared to 6.5% provided through venture capital (British Chamber of
Commerce, 1994; CSBRC, 1995; Bank of England, 1997).

The evidence in this paper is presented in order to help explain how the use of factoring
by businesses varies according to difference in characteristics of the firms concerned and
their relationship with their banks through the availability of credit, size and value of the

3
collateral, total value of the firms debt and also if the business is experiencing financial
distress. It would be expected that firm’s access to factoring and invoice discounting
would vary according to their customer base. It has also been argued that firms will
differ in their experience of problems with access to finance according to their age, size
and sector Binks and Ennew, (1997).

The findings in this paper add to the available evidence on the demand side of factoring
services and complement strongly the supply side analysis covered in Soufani, Binks and
Bruce (1999).

The paper is organized as follows. Section 2 will briefly present the theoretical
backgrounds and issues relating to credit and finance gaps. Section 3 discusses the
definition and process of factoring. Section 4 discusses the development of the UK
factoring industry. The data and sample characteristics will be in section 5, while the
testable hypothesis and the basic results and findings will be presented in sections 6 and 7
respectively. Conclusions are given in section 7.

2. Finance Gaps: background and issues

Many over the years have covered the theoretical and empirical debate pertaining to the
existence of credit rationing and finance gaps. In the UK these financial difficulties seem
to mainly confront small-medium size enterprises. The theoretical debate hinges upon
Principal and Agent theory and asymmetric information with the resultant potential for
adverse selection and moral hazard. This has been well identified through the work of
Stiglitz and Weiss (1981) and De Meza and Webb (1987) with more recent contributions
by Cressy (1996). Empirical evidence has been collected from a wide variety of surveys.
Some of these have been based on official reports (Macmillan 1931; Radcliffe 1959;
Bolton 1971; Wilson 1979; Rhodes 1984; NEDC 1986; Hall 1989; ACOST 1990; Bank
of England 1994, 1995,1996, 1997,1998,1999). Work on the changing nature of the
equity gap is well established, for example, through (Bester and Hellwig 1989, Mason
and Harrison 1994) where the latter defined it as “primarily a shortage of seed, start-up
and early stage finance”. The evidence of a debt gap has been provided through regular

4
surveys, such as the one conducted by the Forum of Private Business (Binks and Ennew
1994, 1996, 1998) and many others.

It is recognised that many firms do not require immediate cash payment for their
merchandise, which gives rise to trade credit; an area most likely to absorb unnecessary
cash from the business. Firms normally seek bank credit in the form of short-term loans
and overdraft facilities; however, many report problems in terms of access to external
finance, delayed payment and the management of working capital and cash flow control.
It is the underlying causes of these difficulties and the most appropriate strategies for
their alleviation that is the subject of vigorous debate. Firms attempting to finance smaller
projects through debt finance may confront a ‘debt gap if they have insufficient access to
collateral. The case was argued by Binks 1981 that “the smaller the firm the larger the
proportionate increase in capital base required to respond to an increase in demand but
the lower its ability to command loan and equity finance”. This was extended through
the work of Scott (1992) who argued that the size and age of the firm are also inversely
related to its ability to command finance. It was also observed that the financial expertise
of management and the burden of security would tend to be greater for younger and
smaller businesses. Market volatility and delayed payment will also tend to compromise
working capital control in smaller and younger firms.

3. Is Factoring a solution?

From the above it is clear that access to finance and financial control present problems to
many SMEs. Debate around the underlying causality is not relevant for the purposes of
this paper. The evidence also suggests that younger and smaller firms and those
requiring significant capital outlays may be more prone to access and management
problems. Factoring and invoice discounting would appear to offer some solution to the
problems of access to and management of working capital. From the supply side it might
be expected that these firms could constitute a significant market for the sale of factoring
and invoice discounting services. Little systematic work has actually been undertaken to
establish whether this is the case.

5
Factoring involves a process where a specialized firm assumes the responsibility of the
administration and collection of the account receivables for its clients. It can be
considered as a form of short-term commercial financing based on the selling of trade
debts at a discount, or for a prescribed fee plus interest. The mechanism of factoring
involves the interaction of three types of firms or economic agents, the client firm, the
customer firm, and the Factor. The client firm provides its customers with goods or
services for payments on terms ranging in periods between 30-90 days. The firm is
typically a supplier of a good or service, and its credit accounts are classified as accounts
receivable. The customer firm, is the one that buys goods and services from the supplier
and therefore has the obligation to make the financial payments within a stipulated
period. The third economic agent is the factoring firm; it provides the client firm with
specific functions, namely, it substitute cash for accounts receivable, hence placing the
client’s extension of credit on a self-liquidating basis as if it was selling for cash (i.e.
provision of finance for working capital). It assumes the credit risk for the accepted
accounts and thus takes full responsibility for the solvency of such customers to the
extent of the accepted or approved amounts (i.e. provision of credit management). It also
checks the credit and collects the accounts (i.e. sales accounting services).

Mian & Smith (1992) prove using U.S. data that “…accounts receivable management
policy, measured by the way in which it is organized, (is)…an alternative and adequate
measure for the development of a robust theory and the empirical testing of its
implications”. The work done by Smith and Schnucker (1994) was mainly an empirical
examination of organizational structure, where the economics of the factoring decision
was evaluated. Their paper finds that economies of scale have an impact on the decision
to integrate, because credit management internalization is greater when the selling firm is
larger and the percentage of trade credit customers is higher.

Factoring companies often claim that they are the ideal financing option for small sized,
young, and fast growing firms operating in a specific business activity (e.g., Noly, 1969,
Beecham, 1988, Palframan, 1989, Hawkins, 1993, Smith and Schnucker, 1994, Bickers,

6
1994). If this is true then it will be reflected in the pattern of demand by firms for
factoring services.

4. The UK Factoring Industry

The Factoring market has grown steadily. From the supply side, during the 1990s, the
factoring and Invoice Discounting market has grown at a rate of about 21% a year
(Association of British Factors and Discounters (ABFD) 1996). It is estimated that the
industry provides working capital to over 24,000 businesses that between them employ
over half a million people in the UK (Factors and Discounters Association 1998). Two
main associations, namely, the Association of British Factors and Discounters (ABFD),
and another, represented the industry, which is the Association of Invoice Factors (AIF).
In September 1996, the associations merged to form the Factors and Discounters
Association (FDA). This has a total of 34 members accounting for over 99% of the
market. Of these members 26 conduct Factoring and Invoice Discounting, while the
remaining 8 carry out Invoice Discounting only. The total UK market for Factoring and
Invoice Discounting was worth over £41bn in 1997, of which Factoring (including
international) accounted for over 34% of the market standing at about £14bn (Soufani,
1998). Bank owned factors account for 93% of the market and independents the
remaining 7%.

During the early 1970s the U.K clearing banks began to participate in factoring and so
there began the process and mechanism through which the concept of service factoring
gained ground. Therefore, it would be fair to say that the basic shape of the present U.K
factoring industry was laid down by the mid-1970s. It was during this period that the
service aspect of factoring was emphasized, the higher quality of the client was
demanded, and the techniques of the factor was accepted not only in the textile industry
where the historical association lies but also throughout the business community. This
period saw the increased interest and involvement of the banking institutions; this was
evident by seeing the Bank taking a controlling shareholder position in most of the
factoring companies. It was estimated by Forman (1976) that the sales factored per
annum by the mid 1960s were in the region of £100 million and over £1billion in the

7
1970s. In 80s the market expanded where it stood at £2.8bn in 1982, and now it has
reached about £52 billion according to Factors Chains International (1999) an umbrella
organization for factoring companies worldwide.

5. Sample Characteristics

The results of the analysis where derived from the survey of SMEs by the Forum of
Private Business, Binks and Ennew (1996). This was the 5th biennial survey of the
relationship between SMEs and their banks and the first to include a question on the use
of factoring and invoice discounting. The survey recorded a total response of 3805 firms.
This constituted a response rate of around 30%. In terms of turnover the size distribution
is skewed towards larger businesses with around a quarter of respondents represented in
the smallest size category of £150,000 - £500,000, nearly one fifth in the category
between £500,000 and £1m, and one fifth citing turnovers of over £1m. The sectoral
distribution comprised of 10% in primary, about 20% in manufacturing, nearly 30% in
distribution and 30% in services with 12.5% citing ‘other’ as a category. The average age
of firm was 16.69 years with over 55% between 1 and 10 years old. . Therefore, there is
sufficient representation in all categories for the purposes of this analysis. The statistical
analysis was based on a chi-square test, logistic regressions, t-tests, and Pearson
correlation in order to explore the relationship between the extent of firm demographics
and Factoring use

Two hundred and twelve firms used factoring accounting for around 5.6% of
respondents. This result is consistent and close to the findings of other studies which
investigated alternative forms of financing small enterprises in the UK. Such as the ones
conducted by the Financial Times (March 1993), British Chamber of Commerce
(February 1994), and the Cambridge Small Business Research Centre (CSBRC 1995) all
of which reported average proportions of about 6%. More detailed comparisons of the
overall survey distribution and those firms using factoring are presented below, given the
extensive coverage of the survey of the relationship between banks and their small
business clients we test an additional set of hypothesis:

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6. Testable Hypothesises

A comprehensive survey of factoring service suppliers in the UK in 1997/98 Soufani,

Binks and Bruce (1999) and the one conducted by for the Forum of Private Businesses
(1996) revealed the following characteristics in terms of the profile of the customer base
and its relationship to the banking sector. They are treated as hypotheses for the purposes
of analysis presented below.

H1: Businesses using factoring are relatively small when measured either by
employment or turnover.
H2: Factoring services tend to be more focused upon manufacturing and distribution.
H3: Factoring services tend to be focused upon firms of 1 – 5 years old.
H4: Factoring services focus strongly upon limited companies.
H5: The less is the availability of credit by banks the higher the usage of factoring
H6: The less realistic the collateral requirements the higher the use of factoring.
H7: The use of factoring increases the higher is the value of collateral requested by
banks.
H8: The higher the amount of debt, the more the business will use factoring
H9: The greater the financial difficulty the business is facing the higher is the use of
factoring.

(Insert Table 1 about here)

7. Basic results and findings

7.1. Factoring and Business Size

The analysis of suppliers of factoring services (Soufani et al, 1999) suggested that the
bulk of the market consisted of firms with turnovers of less than £1m. Evidence from
interviews also suggested that the smallest and youngest firms would rarely gain access
to factoring services. This would support the argument in theory that the smallest and
youngest firms would be excluded on the basis of low levels of business activity with
associated low levels of potential factoring requirements or due to a lack of experience

9
and track record. Conversely, more established and larger businesses might be expected
to have developed more sophisticated relationships with their banks and other sources of
finance alongside more developed invoicing and payment systems. Table 2, supports the
evidence collected from factoring suppliers and the arguments put forward for supposing
that factoring would tend to be concentrated in a size band between the smallest at around
£250,000 turnover and £3m.

We find a significantly positive relationship between factoring use and turnover except
for less than £250 and over £3 million in annual turnover. This finding supports the
theoretical notion that small new firms at their inception stage may have difficulty in
raising any form of external finance; this is also evident in the invoice financing market.
This finding is consistent with the argument that factoring firms need to observe
sufficient sales generated by their clients so that they can diversify their risk by
controlling for a higher number of invoices issued and also a wider exposure to the
customer base of their clients. As for turnover above £3 million it is argued by Soufani et
al (1999) that firms reach a growth or success stage that may render the use of invoice
financing inefficient in terms of cost effectiveness and the wider availability of
alternative financial resources such as bank credit. Therefore, it can be argued that if
financing by factoring is considered in the context of the stage model theories put
forward by Churchill and Lewis (1983) and Scott and Bruce (1987) we may expect the
existence of a stage model of financing the growth of small businesses. Where factoring
can be considered as suitable option at a certain stage of the firm’s development

The evidence is not unambiguous, however, in that the distribution tends to support the
case for assuming that the smallest firms have less access to factoring but indicates a
significantly higher than expected incidence of factoring in firms with over £1m turnover,
therefore, H1 is accepted.

7.2. The Demand for Factoring Services by Sector

The evidence collected from suppliers of factoring services indicated a particular focus
upon manufacturing businesses. This may reflect particular characteristics of such firms

10
in terms of customer base and invoicing procedures. It could also reflect a higher level of
demand by such businesses due to their greater susceptibility to delayed payment and
collateral requirements (Binks and Ennew 1992, 1994, 1996). The evidence from the
findings of this research is indicated below in table 2. To analyze the results by industry
we find that in the case of the negative sign next to sectors such as Construction, Mining,
Retail, Financial Services, and Profession, these sectors are less likely to use factoring.
This result is consistent with the one found by Soufani (1998) where factoring companies
tend to exclude certain industries on the bases of many issues relating to stage payment,
complicated contracts, and a less diversified customer base. However, the evidence is
clear from the findings that Manufacturing, Transport and wholesale constitutes the main
clientele for invoice financing. H2 is accepted

7.3. Firms’ Age and Factoring Services

The pattern of demand in terms of age supports the emphasis upon younger firms by
factoring suppliers. The evidence is only partial since the sample frame excludes firms of
less than 1 year old. Nevertheless, there is a significant bias towards firms between 1 and
10 years old with a particular focus upon those of one and five years old. The result was
significant using the three statistical tests applied in this paper and exhibited in table 2.
We accept the third hypothesis.

7.4. Firm Ownership and Factoring

Again there is a significant bias towards limited companies in the population of firms
using factoring services. From the following table we can see that the sole proprietors are
less likely to use factoring in relation to limited companies, however the relationship is
not significant. As for partnership they are also less likely to use factoring in relation to
limited companies and it is a significant result, hence H4 is accepted.

(Insert Table 2 about here)

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7.5. Credit availability
The survey questionnaire addressed many issues relating to the availability of credit and
the relationship between banks and the SME sector in the UK. One of the questions was
to rank using a lickert scale 1-5 (where 1 is very poor, and 5 is very good) how well the
firms think that their bank supply a particular requirement, one of the requirements is the
availability of finance. The mean result in table 3 show that those firms who use factoring
selected the lower number in the scale i.e. tending towards the poor provision of finance.
The literature accentuates the existence of credit rationing confronting the small business
sector. Therefore, by evaluating whether there is an association between the availability
of credit and the usage of factoring we may infer that in their search for different sources
of financing borrowers might opt for the factoring and invoice financing choice. The
findings indicate that the less helpful the banks are with the availability of finance to their
small business clients that the higher is the tendency for these businesses to use factoring.
The t-test indicates a significant relationship therefore we accept H5.

7.6. Collateral requirements and value

It can be expected that if banks demand high levels of collateral to secure loans then this
may place pressure on the business to seek alternative financing sources this assumption
is consistent with the arguments put forward by Binks et al (1992). However, the finding
in this study show insignificant result to the relationship between collateral requirement
and the use of factoring, this may be due to two main reasons. Firstly, businesses realize
that credit is rarely granted without the availability of collateral. Secondly, factoring
companies will demand other forms of collateral such as account receivables and the
management of the sales ledger. Therefore we fail to accept H6. However, it is found that
there is a positive and significant relationship between the value of bank collateral and
factoring use. This relationship represents a different dimension, requiring a collateral
and quantifying the value of it are two different aspects. Banks normally require some
form of collateral but when the value is beyond what the business is able to offer then the
business may face credit rationing, which is typically encountered by small firms, the
argument is consistent with Mason and Harrison (1994). Consequently, the small
business seeks an alternative option such as factoring. Therefore we accept H7.

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7.7. Bank loans and factoring use
The choice of capital structure and the effect on the financial policy of firms is a source
of continuos debate amongst academics. The degree of leverage that businesses are
exposed to tend to influences the financial decisions of enterprises (Michaelas et al 1999).
Therefore it is worth identifying if there exist a relationship between the value of bank
loans businesses have and the usage of factoring. We find significant relationship which
indicates that the higher the value of the loan the more inclined the borrower is to use
factoring; therefore, we accept the eighth hypothesis. This can be due to the fact that as
businesses exhaust their allowable debt ratio based on the available collateral, then any
increase in the need for liquidity has to be met by resorting to other sources such as
invoice financing. This is an interesting result that invites further research and
corroboration.

(Insert table 3 about here)

7.8 - Financial difficulty and Factoring

The existence of cash flow problems and cash shortages will almost certainly lead to
substantial financial difficulty and financial management problems that force firms to
request bank credit in the form of loans or overdraft facilities. The factoring firms often
claim that they are the ideal financing option for cash strapped businesses. Therefore, it is
useful to explore if there is an association between the existence of financial difficulties
and factoring use. Conducting a Pearson chi-square test reveal a significant association

[χ=14.302, df = 1, p= (.000)] between the use of factoring and the prevalence of financial

difficulty by the firm, therefore, H9 is accepted.

8. Conclusions
This paper has developed and tested hypotheses that explain the main determinants on the
factoring and invoice financing choice. The evidence from the demand side for factoring
is consistent with perceptions of the suppliers of those services to indicate that there is
indeed a focus of provision according to business characteristics. The evidence supports
the hypotheses presented in terms of size, sector, age and ownership. Also evidence is

13
found to establish a relationship between the banking services offered to borrowers and
the factoring choice. Purchasers of factoring services in the UK tend to be smaller firms,
more likely to be found in manufacturing and associated industries, younger and limited
companies rather than partnerships or sole proprietorships. In addition to that they are
businesses that experience credit crunches, have high value of collateral and loans, and
experience financial difficulties.

This evidence taken with that collected from the suppliers of factoring services confirms
the focussed nature of factoring provision but does not provide clear evidence on the
underlying causes. Suppliers of factoring services will tend to focus upon businesses
according to the relative risk associated with their customer base and invoicing
arrangements. The demand for factoring services will tend to reflect the relative impact
of financial constraints upon firms and in particular the impact of delayed payment upon
working capital and liquidity. The area of active demand and receipt of factoring
services represents the extent of overlap between these forces governing supply and
demand. The sub-set of firms both demanding and receiving factoring services will
exclude those firms who could benefit but do not qualify under the explicit and implicit
selection criteria operated by suppliers. It also excludes those firms whose suppliers
would readily accept but who have access to alternative and preferred sources of finance.
Although the present evidence does not enable the calculation of the proportion of firms
who would benefit from factoring services but who do not have access to their provision.
It is clear that large portions of the small firms sector are effectively excluded on account
of lack of knowledge and awareness of the potential role of factoring as a choice of a
financing source.

14
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 Table 1:
Descriptive Statistics of Respondent Firms

Turnover Number of firms in sample % of firms using factoring

Less than £19,999 58 (1.6%) (3) 1.4%
£20,000 - £49,999 226 (6.2%) (5) 2.3%
£50,000 - £149,999 717 (19.8%) (18) 8.4%
£150,000 - £249,999 554 (15.3%) (31) 14.5%
£250,000 - £499,999 729 (20.1%) (50) 23.4%
£500,000 - £749,999 382 (10.5%) (21) 9.8%
£750,000 - £1m 258 (7.1%) (22) 10.3%
£1m - £3m 499 (13.8%) (44) 20.6%
Over £3m 186 (5.1%) (19) 8.9%

Sector Number of firms in sample % of firms using factoring

Construction 261 (7.1%) (11) 5.6%
Manufacturing 731 (19.6%) (66) 31.5%
Transport/Communication 117 (3.1%) (7) 3.3%
Wholesale 226 (5.9%) (24) 11.3%
Retail 789 (20.8%) (28) 13.2%
Agriculture/Forestry/Fishing 63 (1.6%) (4) 1.8%
Financial Services 89 (2.3%) (3) 1.4%
Services 704 (18.5%) (34) 16%
Professions 336 (8.8%) (9) 3.7%
Other 475 (12.5%) (26) 12.2%

Age Number of firms in sample % of firms using factoring

Less than 1 year 48 (1.3%) (2) 0.9%
1-5 years 608 (17%) (63) 29.7%
6-10 years 890 (24.9%) (59) 27.8%
11-15 years 637 (17.9%) (26) 12.2%
Over 15 years 1385 (38.8%) (62) 29.2%

Organizational form Number of firms in sample % of firms using factoring

Sole proprietors 936 (24.6%) (36) 17%
Partnerships 1042 (27.4%) (32) 15%
Limited Companies 1822 (47.0%) (144) 68%

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 Table 2:
Logistics Regression, Chi-square and Asymptotic t-test Ratio of Demographic
Determinants

Explanatory Coefficient Standard Error chi-square T-test

Variable Estimate
Size: - Turnover .1314 .0435 9.1318** 3.02

Sector:
Construction -.1165 .3634 .1027 0.3205
Mining -3.5059 15.6931 .0499 0.2234
Manufacturing .5687 .2464 5.3254* 2.3080
Transport .2161 .4459 .2349 0.4846
Wholesale .6284 .3055 4.2326* 2.0569
Retail -.1541 .2966 .2699 0.5190
Agriculture .3615 .6387 .2406 0.4905
Financial Services -.2286 .6286 .1321 0.3636
Services -.777 .2788 .0777 2.7869
Professions -.3615 .4282 .7128 0.4420

Age: -.0293 .0070 17.4842** 4.185

Legal form 9.5462**

Proprietors -.3485 .2380 2.1443 -1.46

Partnership -.6738 .2200 9.3784* -3.062

Constant -2.9829 .3494 8.53

**Significant at 0.01 level

* Significant at 0.05 level

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 Table 3:
Firms’ credit situation and factoring use
Determinants Mean Mean Std. t-test Significance
Use Factoring No Factoring Deviation

Credit Availability 2.5069 2.7376 1.1571 3.057 .009

Collateral 2.8358 2.6716 1.0807 2.374 .64
Value of Collateral 255.51 164.26 343.82 2.078 .038
Value of Loan 132.27 87.94 197.37 2.609 .009

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