Grow! eZINE

FACTORING INTRODUCED

By: Patricia J. Burns

Factoring can best be described as a tool to increase cash flow. If you understand your businesses cash flow cycle then you will appreciate how factoring can assist you. A factor advances funds against accounts receivable. By funding on the receivable as it is generated rather than waiting for the terms of sale to mature, a company shortens its operational cycle. A company with positive cash flow can take advantage of opportunities that will make the difference between growth and stagnation.

If your production cycle is lengthy you will need to obtain long term working capital and factoring may not provide you with adequate cash flow relief. However, if your operational cycle is less than ninety days factoring may be a non-borrowing and non-equity solution for your growth. The operational cycle of a business varies with different industries. However, for our discussion, it is the length of time from the point of sale until cash is received for that sale, that is the operation cycle.

In this introduction to the factoring industry, I will examine the types of factoring available. This will include non-recourse and full recourse. You will also develop an appreciation for the multitude of services that factors offer. Also, how the diversity of these services can be the extra hand you need to develop a strong business.

I will provide direction on how to select a complementary factoring relationship. You will learn how the process of factoring begins from the point of sale. I will guide you through the credit investigation, the funding on the account and the collection process. I will point out the cost and fees. Ultimately you should have an understanding and appreciation of opportunities that can be taken advantage of with increased cash flow.

 

TYPES OF FACTORS

There are many types of factors; however, they all offer funding on accounts receivable after they are generated. Most factors recognize a receivable only when the product or service has been delivered or provided. The factor funds once he has received your invoice, proof of delivery and any other documents that may be required to process payment. The funding is predicated on pre-approved accounts and the acceptance of these documents and occurs generally within 24 hours. If you are billing in advance of delivery it is not generally viewed as a receivable.

Traditional factoring is provided on a non-recourse basis. This means that the factor guarantees the credit of those accounts they approve. By selling your rights to collect on the accounts, you receive the benefit of accelerate cash flow without incurring debt. A factor that offers non-recourse funding will make the investment to clear the credit. After all, it is the debtor of the client, which is the sole source of re-payment.

There are also factors that offer advances on the receivable with full recourse. This means that you, the client, guarantee the credit. There is little incentive to make the investment in the credit of the customer, if ultimately you are liable for re-payment of the bill. A factor that provides funding with full recourse generally will sell you back the bill at a specific time. Recourse is normally at sixty to ninety days. This means if your customer has not paid the factor within sixty to ninety days that you will be required to pay the factor back.

Both types of factors provide some form of collection service. Again the non-recourse factor has more incentive to monitor the accounts than the full-recourse factor. In either case, factoring is considered riskier than any other form of financing. All factors will monitor their collateral base to insure the collectability of the accounts, which they have funded against.

Although the concept of factoring is simple, the risk the factor takes is unparalleled. Factors must act as their clients credit advisor, understand the risk or draw back of the industry their client services, and act as the payable department for the clients' debtor. The factor must be assured that the debtor has received and accepted those items, which they have ordered. The complexity of this assignment alone is the factors greatest risk.

 

SERVICES

Factors provide, in addition to predictable cash flow, a variety of services. These services include credit and collection management. The factor acts as a credit department for those clients, which it serves. The level of this service varies with the factor you choose. Industries such as the garment industry sell to boutiques in every mall across the nation. Credit investigation alone can be a full time job for the multitude of small one time sales.

The administration that a factor provides can be the most valuable element of your relationship. The factor will spot check for accuracy and sometimes prepares invoices. They will often provide mailing service of those invoices and will provide statements to the customer base when needed. As payments are received your customers account will be credited. A factor can also provide you with cash receipt journals, so that you can calculate commissions for your sales personal. Your industry will dictate the importance of these services.

A factor that provides collection services will make routine calls to your customer. Payment request is made in a professional manner to anticipate receipt of funds. As payment trends become established with your customer, the credit limits will be reviewed. You will be advised if the delinquency of an account adversely effects future shipments.

Most business owners would prefer to develop product and long term business relationships. By factoring your accounts, you have hired an outside source to manage these accounts. This should relieve you of the collection burden and the gamble of credit extensions. In addition, factoring allows you to manage your company more efficiently by providing you with dependable cash flow.

 

CHOOSING A FACTOR

The acceleration of cash flow can provide you with growth potential that is limited only by your ability to market and produce a quality product. In choosing a factor, you should find one that has sufficient strength to support your business. This means that the factor should understand the industry you service. You should choose a factor applying the same standards you would in choosing a financial partner. Ask the factor for references. Because the factor will be supplying you with cash flow for the growth of your business, understand what the factors limitations are.

In 1993 the volume of factoring in the United States grew to over $50 billion dollars. Ten megafactors dominated ninety percent of those sales and most of these factors are owned or controlled by bank holding companies. The three largest of these megafactors are CIT Group/ Commercial Services, BNY Financial, and Nations Banc Commercial. There continues to be consolidation in the factoring industry as there is in the banking industry. With this consolidation just as they have in the banking industry voids have emerged. We are now beginning to see many small community factoring companies scrambling to fill this void.

Factoring is a special art and although many of these new community factors will succeed, proper capitalization of these firms is critical to their success and yours. An experienced factor can anticipate your growth potential. As in any business positive cash is the key to success. This holds true for the factor as well.

The megafactors will generally require a minimum of one to two million dollars in annual sales. Their capital requirements are generally ten percent of annual sales. In other words, if your annual sales are two million dollars you should have a capital net worth of $200,000. They ordinarily require that you guarantee a minimum fee for the service of your account. This of course includes the credit and collection services but does not necessarily include interest.

You may in some instances only request the services and not require borrowing until a later date. This is what is known as maturity factoring. A maturity factor funds when the bill becomes due or at a later date. In these particular factoring relationships you may be borrowing directly from the bank and the factor complements or guarantees the banks involvement.

The smaller factoring company like Primary Funding Corporation does not necessarily have capital requirements. However, we will want reassurances that there are sufficient profits to absorb the factoring fees and support the business. We can often factor a start-up simply by understanding the nature of the product, the sale of the goods and the credit of the customer. Because the capital requirements are lenient the risk is assumed to be higher. If for any reason the invoice is rejected there are very few ways for the factor to recover.

A factor must anticipate failure and protect themselves from the multitude of reasons for failure. This is especially true when a companies resources are insufficient to repay the factor if rejections occur. A non-recourse factor can only guarantee credit and cannot guarantee the product or the sale of the product. The factoring industry is also prone to fraud and conversion.

One company, which I factored, designed and sold women's bathing suits. They contracted out the sewing of these suits. We approved a thirteen thousand dollar credit for his debtor. We called and confirmed the terms, pricing and quantity of merchandise with the customer. We also confirmed receipt of goods. This merchandise was shipped towards the end of the buying season. It was discovered after the merchandise was on the floor that the straps for the tops of the two piece suits were sewn on upside down. The merchandise was rejected and returned. Because the season was over the customer no longer wanted the merchandise. My client went out of business and we were out the $13,000.

In another situation, I had a client that had a sheet metal shop. He produced a product for the US Postal Service. The postal inspector came by on a weekly basis to inspect the product. He issued an inspection report prior to shipment. The client presented to us the signed report, which accompanied the invoice and a bill of lading. It was later discovered that the client was simply moving the finished product from one side of his warehouse to the other. When the inspector arrived he thought he was inspecting new product. My client was forging the signature on the bill of lading and we were purchasing the bills. This client spent some time in prison. We recovered in full.

Both of these simple illustrations are meant to point out that the risk a factor takes is unique. The importance of your financial partners understanding of your industry is paramount to success.

 

HOW DOES IT WORK?

To summarize, factors offer a variety of services. The factor you choose should assign you an experienced credit manager to service your needs. Your credit manager or "Account Executive" will supervise the daily collection activity on your account. An experienced account executive will be able to evaluate credit and financial statements. These evaluations are made possible by using credit reporting agencies, the factors vast network of affiliations and by monitoring your customer's payment trends. The account executive is responsible for communicating and coordinating the credit approvals on your accounts prior to shipment.

The cost to provide services is a major element in pricing a factoring candidate. The administration of your customer base may be labor intensive meaning you have a lot of rotation of those customers. A factor must take into consideration the number of customers you have and the number of invoices processed.

The factor must evaluate the risk; this would include the credit worthiness of your customer and your own track record of delivering acceptable product. The less time you have been in business the more difficult it is for the factor to evaluate this risk. The more confident the factor is in your capital strength the less risk the factor takes on. The fungibility of your product or service and the less unique it is will reduce risk and lower cost.

A part of the risk assessment is anticipating how long it will take to receive payment from your customers. A factor will not generally extend credit even with full recourse to accounts that are known to be slow paying. A factor will want to avoid high concentrations of a particular customer in their portfolio, regardless of the credit strength, just as a bank does.

 

COST

Fee's for factoring services vary for all of the above reasons. Your level of commitment to the factor can lower cost. However, if your business history does not support the ability to make a commitment your fees may be higher.

Commitment fees are generally in the form of term contracts. If you sign one of these contracts it will most likely be for one to two years. The factor guarantees you the availability of the funds for a minimum monthly fee. If you choose not to use the factor's services, or you become disenchanted with your financial partner, you have a contractual obligation to pay this fee. This is much like a lease obligation or a discount that you would receive for committing to purchase a large quantity of goods. Especially under these circumstances make sure the factor you choose is one you can live with. An early termination or reduction in anticipated sales can substantially negate any cost savings these programs may offer.

There is also spot factoring. A spot factor finances the transaction. There is generally no obligation to use the services of a spot factor. A spot factor may have a line fee, which reserves availability for you without guaranteed usage. A spot factors program is generally very simple. They can provide all the services described and yet they provide flexibility to their clients in choosing the customers they wish to factor. A company that chooses spot factoring generally expects the need to factor will be short term, seasonal or due to an unusual one or two time sale.

Primary Funding provides spot factoring to many companies who are not prepared to make a long-term commitment. Spot factoring is frequently used prior to a stock issuance because the agreement can be terminated by the client purchasing back the portfolio. Primary Funding also sees it being used as a tool in a leverage buyout because it provides liquidity during the interim. A spot factor tends to be a little more expensive because the transactions tend to be fewer and or smaller. I have often compared a spot factoring program to the use of a revolving charge card. You simply use the factor when you need the cash.

If you qualify with a megafactor whose requirements can be as strict as bank financing, you will most likely pay a factoring commission on all credit sales. The factoring commission you are quoted is based on your annual sales. This fee can be as low as one half of one percent but more than likely it will be one to two percent. They will also charge you interest on the borrowed funds. The interest rates can be competitive with bank charges.

The community based factors like Primary Funding, who typically take on riskier portfolios, charge transaction fees or some other form of pro-rating based on the length of time your account remains outstanding. Pro-rating offers you an advantage of lower fees for faster paying accounts; however, you must be prepared to pay more for slower paying accounts. However, fees inclusive of all the services offered coupled with the risk and volume could be as low as 2.5 percent and generally no more than six percent.

The programs offered with pro-rating vary considerably. The key is how fast your accounts turn, the credit strength of your portfolio, the risk of your industry, the number of transactions, the total dollars involved, and the factor's perceived exposure. When you think of the ways you quote fees for your products and services you offer, it is easier to understand how the cost vary in managing different portfolios.

The advance level for each of these programs is dependent on the perception the factor has of your company. Advances on receivables can be as high as 100% and as low as 60% but generally it is between 70 to 90%. The advance is what the factor initially funds you when you present invoicing. The difference is refunded, less any fees, when the customer pays the bill. This difference is what is known as the reserve.

There are many reasons, even with the high cost of factoring that firms choose factoring over traditional bank financing. Factoring avoids the embarrassment of not being able to extend terms to a creditable customer. By being able to extend credit, it should allow you to sell your product or services to a larger customer base. By receiving immediate cash for each sale, factoring should provide you with the ability to expand your business at an accelerated rate.

Factoring is not a substitution for term debt, it is an alternative. If you require long term capital improvements, you should consider leasing or term debt. If your production cycle is lengthy then you should also consider term debt. However, if you find your sales could increase by, extending trade credit and you don't have the cash flow to support them, then factoring can be a good alternative. This is especially true if you have a seasonal product. It also holds true when your history cannot support debt. Because you are selling your accounts, factoring is a cash infusion that does not create debt.

Factoring cannot be compared to bank financing. It is a service that is difficult to quantify. Not all industries can benefit by the use of a factor. However, the primary reason companies explore factoring is to increase their cash flow. It has been said that cash flow can be more important than profits. Certainly this is true short term. The window of opportunity that can be taken advantage of because of positive cash flow may be the difference between growth and stagnation.