Factoring of Accounts Receivable

GLOSSARY

Factoring:  Selling of accounts receivables (usually to a bank or finance company) for a discounted amount.  The purchaser of the receivables is known as a factor.  Worldwide volume of factoring now exceeds a trillion dollars of transactions per year (with growth at the double-digit level and outstanding credit at any point in time over $100 billion).  Factoring is most popular in Europe (with $400 billion in volume) with the U.S. second (at $200 billion); Asia has approximately $100 billion in volume.

Recourse:  The ability to be reimbursed for any losses due to bad debts.  If a factor buys accounts receivable on a recourse basis, the factor may ask for (and receive) reimbursement from the company for any bad debts among the receivables.

Non-recourse: The inability to be reimbursed for losses due to bad debts.  If a factor buys accounts receivable on a non-recourse basis, the factor is responsible for any bad debts among the receivables.


Need for the Service

Factoring has a long and rich tradition, dating back 4,000 years to the days of ancient Mesopotamia.  During the European Renaissance, it helped to make the Medici family very rich.  Merchant bankers in London advanced funds to the American colonists under a factoring arrangement when furs, lumber, and cotton were shipped to Europe.

Prior to the 1930's, factoring in this country occurred primarily in the textile and garment industries.  Today, factors exist in virtually all mainstream industries.

The most basic question in the field of corporate finance is this:  "I must pay out money (for labor, materials, etc.) to produce and sell my product.  Then, because I grant credit to my customers, there is a lag of several weeks or months after the sale before I get paid for that product.  Where do I find the funds to finance this gap in time?"  In other words, the company has a cash flow problem - cash goes out in large amounts before it starts to come in. This is especially true of rapidly growing firms and firms with large customers. It is now common practice for large companies to employ sophisticated cash management strategies that stretch the time for invoice payments as long as possible. That is great for the large firm, but it can put the supplier in a crushing cash crunch.  Meeting operating expenses, or even financing the next job from a client, becomes a real challenge due to the shortage of funds.

Factors step into this void and meet the need.  They purchase a company's invoices (i.e., accounts receivable) and give the company an immediate cash advance for the invoices.  (Typically, the factor will pay about 80% of the receivables' value and hold the remaining 20% in reserve until the receivables are paid.)  Then, at the appropriate time, the factor collects on the invoice from the customer and returns the reserve balance, minus the previously agreed-upon fees.  The factor actually buys the legal right to collect a company's outstanding invoices. The factor gets its money when the invoices are paid. The business gets its money now, minus a fee that can run as high as 3% of the amount due.  By factoring its receivables, a company is essentially outsourcing its credit management and collection of receivables.

Accounts receivable is a business asset just like a piece of property.  As such, they can be bought and sold.  Factoring arrangements may be structured on either of the following conditions:

Advantages

Factoring offers several advantages over alternative forms of short-term financing.  Let's look at a few of these:

  1. Improved cash flow - Rather than having to wait weeks or months for payment of the receivables, the company can receive cash within 24 to 48 hours by factoring them.  Large companies (e.g., Wal-Mart) manage their cash very efficiently - often, this means that they pay their bills very slowly (thereby earning interest on the cash before it is paid out).  Their credit may be excellent - they will eventually pay their bills; it's just that you may have to wait a while.  This is an excellent situation for a factor since there is almost no risk that the large company will never pay.  They are more than willing to advance funds to a company that sells to Wal-Mart or a similar large company.

    Of course, factoring doesn't provide a business with "extra" funds - -it just speeds up the receipt of money that would eventually be collected anyway. Nevertheless, having access to receivables almost instantly provides a degree of flexibility that is essential to many businesses experiencing above-average rates of growth.

  2. Reduced credit granting/collections cost - If a company factors all of its receivables (rather than just part of them) on a non-recourse basis, the company can eliminate its own credit department, thereby saving considerable money on credit granting and collection of overdue bills.

    When the company receives an order, it simply calls the factor to see if it will "accept the paper."  The factor quickly checks the creditworthiness of the client's customer, approves the credit before shipment, and then takes the responsibility for collecting the money.  Since the factor is frequently a bank or finance company, it is in a much better position to evaluate credit applications anyway, as well as collecting any overdue accounts.  In theory, this should mean better, quicker, and more cost-effective credit decisions.  Much of the evaluation of a customer's credit risk is shifted from the company to its factor, creating an opportunity to reduce credit and collections department expenses such as wages, benefits, and infrastructure costs.

  3. Credit protection - By selling its receivables on a non-recourse basis, the company isn't responsible for credit losses on the receivables portfolio.  The credit risk is transferred to the factor (in exchange for a fee).
  4. Credit availability - Businesses that have not been operating for very long or have insufficient hard assets might have difficulty obtaining a bank loan but can obtain the needed money through factoring.
  5. Low hassle factor - There is relatively little "red tape" or high set-up fees involved with factoring. 

Disadvantages

  1. A lingering negative image - For years, factoring was viewed in a negative light.  Once a customer heard that you were selling your receivables, they often thought, "Why are they telling me to pay the bank (or finance company) rather than the company?  Are they having financial problems?  If they are in danger of going under, maybe I should find a more dependable supplier for my needs."  Although factoring is widely accepted today as a legitimate financing tactic, there may be isolated cases where unenlightened customers may view factoring as a negative.

    If customer-supplier relationships are deeply rooted over many years, some customers may legitimately wonder why a factor is being added to the relationship. So it's crucial that explanations be given, usually in the form of letters to customers, that detail why the supplier's changing needs (growth, expansion, etc.) have warranted the use of factoring.

  2. Cautious factors - Factors also won't necessarily advance money for all of your invoices. After all, they won't let you push off all your "junk" receivables onto them (at least, not without having to pay a huge discount).  The factor can select from just those it believes are most likely to pay up.  Discount rates may be much higher on so-called "non-recourse" paper, where the factor's potential losses are higher.
  3. Loss of control on collections - As attractive as not having to worry about collection of receivables sounds, keep in mind that you can't control the factor's collection tactics if you sell on a non-recourse basis.  By selling on recourse, you may possibly save a customer who could be lost if the factor pushes too hard.  However, it is in the best interest of the factor to maintain good relations with the customer as well; after all, turning off a customer may be equivalent to losing a valuable account.

The Mechanics of Factoring

Improved technology has allowed factors to create online factoring services that allow the business owner to factor items almost immediately. The factor takes care of all the paperwork, while the company follows the progress via the Web.  Everything is covered, from generating the invoice to cashing the check to depositing the funds in the company bank account.

The arrangement is often set up as follows:

  1. The contract, typically for a one-year period of time, is negotiated.
  2. The issue of recourse vs. non-recourse is resolved.
  3. The amount of the discount (often 2% to 3%) on the receivables is specified.
  4. The amount of the reserve, frequently 20% of the total receivables, is determined.  This amount is withheld from the company until the end of the contract period.  The purpose of the reserve is to ensure that the receivables are collected as promised.  On a recourse basis, any bad debts are paid out of the reserve account.  Clients can access around 80% of the value of their sales invoices as soon as they raise them with the balance paid when the customer pays.

From that point on, all billing and collecting can be done by the factor.   The P.O. box to which the payments are sent is a classic "lockbox" emptied by the factor, not by the company the customer thinks has sent the bill.  The factor keeps its clients' books showing cash on hand, cash received every day, and accounts still receivable. The information is always available to the company, with password protection, on the factor's website. There are no files, no filing cabinets, no storage space, and no postage and mailing costs.

What actually happens when the customer charges a purchase? At the close of the day, an electronic message is sent from the company to the factor's computers, summarizing all the transactions of the day. The factor deducts its 2 to 3% discount, and usually enough to maintain the roughly 20% reserve, then transmits the rest to the company's bank account.

If the invoice goes unpaid past the due date, one of the factor's credit analysts may talk with the business owner about ways to collect the money. Any bill that isn't paid after, say, 90 days will be identified by the computer and the money deducted from the company's reserve account. When customers are slower paying than the factor expected, it may charge the company a greater discount than the agreed-upon amount (e.g., 3%); if the bills are paid more quickly, the company can get a better deal.

Costs and Terms

Factoring is expensive, no doubt about it.  Most companies are still better off borrowing from their bank rather than selling their accounts receivable to a factor. Bank interest rates are much lower than the 2% to 3% discount the factor will demand when it buys the right to collect invoices.  A 2% discount for an invoice due in 30 days is the equivalent of a hefty 25% a year; 3% is over 36% per year.

But factors will often advance funds when more traditional banks will not.  Even with only a prospective order in hand from a client, a business can turn to a factor to see if it will assume or share the risk. And to the extent that a business has to take up time collecting, the factor offers a reduction in aggravation that may be worth the price of the premium.

A caveat emptor is in order though.  Business owners need to check out the bank and customer references of any factor, since they have been known to go out of business still owing their customers substantial amounts of money held back in reserve from invoices already paid up.

The terms of factoring are affected by all of the following:


Selling/Buying Receivables on an Exchange

Recently, an exchange that matches buyers and sellers of receivables was created in New Orleans. Sellers of receivables may place their accounts up for auction and potential buyers (banks, finance companies, individuals, etc.) can bid on the receivables. By bringing buyers and sellers together in one place, a fragmented market becomes more standardized and efficient, potentially offering better terms and lowering costs. The exchange's website can be found at this link:

The Receivables Exchange

 


Related Subjects

Accounts Receivable Financing

Pledging of Accounts Receivable