Cash flow finance: Tapping into short-term finance solutions
Saudi Arabia Focus
Rafiq Jaffer Partner,Banking & Finance
Rawan AlsawadAssociate,Banking & Finance
Cash flow financing—also known as sales or invoice financing— involves selling book debts at a discount to a bank or finance company for immediate cash injection and access short-term working capital.
Factoring and invoice discounting are ways of raising short-term finance that involve a company selling its book debts and other receivables due from its customers at a discount to a bank or finance company (usually referred to as a factor) for immediate cash to provide working capital. These structures are also known as sales, invoice or cash flow finance.
Factoring involves a legal assignment of a company's book debts, future anticipated debts, and other outstanding amounts to a factor. This allows the company to receive upfront cash in exchange for the transfer of its receivables.
Factoring and invoice discounting are financial structures that can help improve cash flow and enhance liquidity.
The factoring process typically begins with the company providing the factor with a copy of the customer's invoice. Simultaneously, the original invoice and a notice of assignment are sent to the customer, notifying them of the transfer of their debt to the factor. Upon receiving the invoice details, the factor records the transaction in a sales ledger and assumes responsibility for collecting the debt.
There are two primary types of factoring: recourse factoring and non-recourse factoring. In recourse factoring, the company retains the credit risk associated with the transaction. If the customer defaults on payment, the company is responsible for reimbursing the factor for any losses incurred. On the other hand, in non-recourse factoring, the factor assumes the credit risk. If the customer fails to pay, the factor bears the financial burden associated with the loss. Naturally, non-recourse factoring tends to involve higher fees to compensate for the additional risk undertaken by the factor.
Invoice discounting is a financial arrangement where the company assigns its present and future book debts and receivables to the factor through a legal assignment. In return, the company receives a cash advance from the factor, typically a percentage of the gross invoice value, while paying a fee for the service.
There are two types of invoice discounting: undisclosed discounting and disclosed discounting. Undisclosed discounting occurs when the customer is unaware of the discounting agreement. In contrast, disclosed discounting involves the customer's knowledge of the arrangement, often through a notice of assignment included in the invoice.
Similar to factoring, invoice discounting can be either recourse or non-recourse. In non-recourse discounting, the factor assumes the credit risk associated with potential non-payment of the invoices. The factor may mitigate this risk by obtaining credit insurance. Non-recourse discounting generally results in a lower payment to the company, as the factor's credit risk is limited to the customers.
The primary legal method for transfer of the receivables under a factoring and invoice discounting product is the assignment of receivables. The Civil Transactions Law was issued in 2023 (“Civil Code”) in the Kingdom of Saudi Arabia (“KSA”) and covers, amongst other things, general principles governing contract formation, execution, termination, assignment and transfers.
Article 238 of the Civil Code states that a creditor may transfer its rights to a third party except where a specific provision of law or contract restricts such transfer. The creditor is not required to obtain the consent of the debtor to transfer such right unless there is a specific requirement to seek consent. Article 240 of the Civil Code requires the assignor / transferor to notify the debtor of the assignment. The assignment takes effect if accepted by or communicated to the obligor by any “legal means of notification”. Therefore, a notification of the assignment to the underlying obligor is sufficient and consent may not be required.
Where consent is to be obtained, transfer of rights vis-à-vis third parties only occurs if the acceptance or consent is dated and written.
Whilst invoice discounting is a widely used financial structure, it is important to consider the applicability of invoice discounting in accordance with Sharia principles in KSA. Shari’ah compliance requires avoiding the charging or payment of interest (riba), as it is considered prohibited.
In the context of invoice discounting, the discount charged by the factor could be perceived as an interest component, which would not be Shari’ah compliant. Consequently, it may raise concerns about the enforceability of such arrangements in KSA. However, the Banking Disputes Committee, established by the Saudi Central Bank typically separates the interest component from the principal component in disputes related to financial transactions. In practice, this means that if a claim were to be raised, the amount at risk would be limited to the discount element, rather than the entire transaction. Additionally, the discount is charged to the company by the factor, and not to the customer. The factor provides the company with an upfront payment, and it is unlikely that the factor would raise objections to the discount. In order to ensure that the transaction is seen as Sharia compliant the discount needs to be transferred at the par value of the invoice being discounted. In recent years, Shari’ah compliant structures have emerged to address this concern.
In conclusion, factoring and invoice discounting are financial structures that help businesses improve cash flow and enhance liquidity. With the increased use of Shari’ah compliant structures in factoring and invoice discounting products and the enactment of the Civil Code in KSA, there is much more clarity amongst banks and finance companies.
For further information,please contact Rafiq Jaffer and Rawan Alsawad.
Published in April 2024
