The selling of a company’s accounts receivable at a discount to a business that assumes the credit risk of the accounts and receives cash as the debtors pay off their accounts. Also known as accounts receivable financing.

II. SELLING ACCOUNTS RECEIVABLE AND PASSING ALONG THE RISK

For companies whose credit rating is not strong enough to warrant other forms of borrowing, there is the option of factoring or selling the company’s accounts receivable balances for immediate cash. This is a widely used but relatively high cost option typically form 15% to 30%, so companies typically will not choose this source if another option is available to them.

III. ITS WORKING

Here’s how it works. A factoring company or fact or will purchase the customer invoices individually following a detailed review to identify accounts and invoices that qualify. The factor pays the company for each invoice, after deducting a discount, usually 3% to 5% of the amount of the invoice. The discount compensates the factor for two things:

a.Interest on the money from the time it is paid until the customer repays them, and

b.A premium for assuming the risk of collection from the company.

The company then will typically notify their customer that the invoice owed to the company should now be paid to the factor, rather than the company. When the customer pays in due course, the factor receives 100% of the balance due and thus gets their money back, plus their fees. Along with this process is a relatively heavy paperwork load in selling individual invoices, documents flowing back and forth often daily from the borrower to support amounts sold, and from the factor to document amounts collected, advanced, charged back under recourse agreements and so on.

Besides their fees and account by account scrutiny, the factor may build in additional safeguards against loss. It may, for example, purchase invoices with recourse meaning it has the right to sell the invoices back to the borrower if it has not collected from the customer within a certain time, thus protecting the factor from a loss of principal. There may also be other fees and restrictions that effectively increase the cost of the loan even more.

Certain kinds of companies use factoring as normal business tool, perhaps because they have not been sufficiently well financed from the beginning or because margins are so thin that they have been unable to earn enough profits to build a working capital base. The U.S. garment industry, populated by many small, creatively driver businesses, is an example.

IV. HONOURABLE MENTION TO SOME OTHER SHORT TERM BORROWING TECHNIQUES

Flooring – buying inventory without paying for it until it is sold. This is a little like consignment buying, commonly used years ago to induce retailers to carry products they did not want to pay for until they sold. Flooring is a financing method for high ticket items like cars and boats. Dealers cannot typically afford to pay for a showroom full of inventory, so they borrow against the inventory, item by item and pay off the loan when they sell the item. They pay the lender such as capital, a bank or a finance company interest based on how long they held the item on their premises. Financing plans can include only inventory or a combination of inventory and receivables.

Inventory financing – This is another way to use inventory as collateral. It is possible to obtain financing using the inventory a company owns as collateral, but it is not easy. It must be possible to sell the inventory readily if necessary, which means that only certain kinds of raw materials and finished goods will qualify. Even then, the loan amount will be limited to 50% or so of the inventory value and the lender will often want additional collateral as well. Inventory can be hard to liquidate if the borrower defaults on the loan, so the lender has greater risk of loss; constraints on inventory lending limit the lender’s potential losses. There is not much of this kind of lending today.

Purchase order financing – This is going factoring one step better or worse. A company that wins a large customer order that it does not have the cash to fulfill can borrow money on the strength of the purchase order to enable it to manufacture the products needed to fill the order. This is very high risk lending, because the lender is betting the borrower will be able to make the product and successfully deliver it. As a result, the requirements for this kind of borrowing are even stricter than for factoring: strong customer, firm purchase order, borrower with good track record of completing its work and so on. Only the smallest companies with the weakest working capital position or those with unusually large, one time orders, typically seek this kind of financing.

V. COMMON BUSINESS BORROWING METHODS

Terms of borrowing – Factoring

Duration of loan – Invoice by invoice, 30 – 90 days, revolving as new sales are made

Collateral – Accounts receivable

Use – Getting cash from receivables, passing on risk of collection to the lender

Cost – High

Terms of borrowing – Flooring

Duration of loan – one to three years renewable, but borrowings revolve indefinitely

Collateral – High priced inventory, such as cars and boats

Use –Financing showroom inventory of items for sale, which are also the collateral

Cost – Low

VI. DO NOT LET INTEREST COSTS EAT THE COMPANY’S LUNCH

Factoring is a good example of borrowing that is costly enough that it can adversely affect profitability if not used with care, especially by companies with marginal profits. For example a cash scrapped company with a hot product may feel it makes sense to pay a factor to get early access to cash to it can continue to expand sales. But factoring charges add up fast.

Let’s suppose a company factors $1.2 million of sales under a plan that charges 4% per invoice and customer balances are outstanding for two months on average. That means the company borrows, repays and re-borrows $200,000 six times a year, paying $8,000 in fees each time. In a year, the company pays $48,000 in factoring fees but has the use of only $200,000 of the factor’s money at any one time. That is an effective interest rate of 24%. If the company nets 10% pretax profit from sales, its pretax profit of $120,000 has been cut by 40% to gain access to that cash.

Factoring may be a good decision, but only in special circumstances. Managers should do their homework before choosing this option and any decision to use factoring for financing should come with a plan to systematically remove the need in the future.