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Banks and Factoring? What Can They Be Thinking?

In the past ten years, numerous banks have gotten in and out of the factoring industry in one form or another. With the advent of several companies that sold “their concept of factoring” to banks, the industry has changed dramatically. Rates have been driven down to half of what they were twenty years ago and yet, in many cases, the risk has risen.

Banks have primarily concentrated on balance sheets and cash flow. They look at the credit history of the client company to determine if they can reasonably expect the client to service the debt so that their money will return to them with an interest percentage that is connected to prime or LIBOR . As collateral goes, they are most comfortable with a hard asset such as real estate or machinery and equipment. This is their mindset; it is what they have been taught to do.

Then, you have the factoring company. This is an entirely different mindset. They want to know the history and character of the principals of the client they are factoring, but their primary focus is the quality of the commercial accounts receivable. Their credit criteria are the strength and concentration of the account debtors, the opportunity for dilution and several other considerations which are necessary to consider every day, on every piece of business. They understand that the reason they are being used is because a company’s balance sheet does not meet the criteria of a bank’s credit culture. They know and under-stand the risk involved and further understand that monitoring is the key to success fully getting their money returned to them.

So, how do these two cultures reconcile their different mindsets ? Banks have been sold a false concept (and many have paid a high price for the learning experience) by companies that promise them the high return on their money without fully explaining their risk, nor giving them the proper training and tools to properly carry out the daily duties and responsibilities of the factoring company. These companies have very derisively been called “factor in a box” by the factoring companies that know the truth and the high risk that is involved. Banks have been sold on this false concept of “Just use this software and you too can be getting 24%-36% AP R on your money, just like those factoring companies are getting.”. Just use our software and training program and we will generate business for you and then our software and systems will protect you. Then the banks happily put a teller, or an up and coming junior bank officer in charge of the portfolio. Three months , six months , or a year later a deal goes south and the bank wonders what happened. The high returns have evaporated in the loss and they have a bad taste for the factoring industry.

In order for a factoring entity to survive and be successful, it must have three elements ; #1 is capital, #2 is a method of sourcing companies for their product and most importantly, #3 is a proven method of getting their money back along with a reasonable fee for their efforts. Fail in the firs t area and you will prevent growth as having money available is the product, fail in the second area and your product (your money) sits on the shelf and you realize no gain, but fail in the third area and your company is doomed.

For a bank to be successful in the factoring industry, they have to change their mindset and understand these basic principals . They already have the first element, capital and they have it at a much cheaper rate than most factoring companies . They usually have leverage on assets of 12. 5 to 1 and their cost of funds is much cheaper. The second element is, in most cases, right in their bank. They have a built in referral system which allows them to draw on their customer base to loan money when the commercial lending arm is just not able to justify the lending of money based on balance sheets . The third element is what gets them in trouble. Portfolio monitoring is critical and it is not an easy task. So much of the daily decision making process of advance rates , when or should you loan on an invoice is based on experience in the industry. Collateral must be monitored on a daily basis . The very reason that the balance sheet does not justify loaning money is why the monitoring is so critical. It requires a conscious effort on the part of the back room operation on a daily bas is to ensure that the invoices are correct and valid; the debtors are properly notified and are of sufficient credit strength to justify an advance. Someone who does not have experience in the industry is going to lose money. There are just too many snares and traps which can and will trip you up, take your money and take it fast. Factoring is not rocket science but it does take experience and the education process can cost more than 8 years at Harvard Business School. Even the most experienced people will occasionally take a hit in their portfolio but the entire concept is to lessen the risk. The banks that understand this vital third element of success in the factoring industry have flourished, while the ones that have bought into the false theory of a software monitoring package and little or no controls have taken massive hits.

Another point that banks should take into consideration is the rate on return. The very fact of having bank rate funds is a very lucrative position to hold in commercial finance. The inherent costs of the backroom must be taken into account, but also the concept of “Risk versus Return”. So often, with the strong competition that the industry is experiencing, rates are lowered and lowered significantly. Sometimes in the heat of competition for a deal, rates are dropped even further until it is way past the concept of “risk vs return”. This industry sells a product and if you do not realize the return on the product, the industry as a whole suffers . Banks in the industry or entering the industry would do well to keep in mind that comparing the normal rate of return on a commercial loan to a factoring proposal is not the proper way to set your rates . Take all of the other costs in consideration of properly monitoring the loan and the risk of the proposal. Take advantage of the competitive edge that having the high leverage and the low cost of funds allows but cutting rates to the point of not being able to hold the proper amount in loan loss reserves is damaging to the industry as a whole and certainly will come back to haunt the institution that practices wholesale rate cutting.

So, as in most industries, the key to success in factoring is experience and following good solid industry practices . If banks can change their paradigm of thought, they can be successful, however if they buy the concept that has been sold by these “factor in a box” companies, they will continue to suffer losses and do damage to the factoring industry.

Dave Rains is one of the nation’s foremost recruiting professionals . With
over 27 years of sales /recruiting experience and an honors graduate of S HS U, he
has earned a reputation as an expert in the placement of Business Development
and Operations professionals in Commercial Finance. Throughout his career,
Dave has been recognized as a top performer within the MRI family of over 1, 000
offices . He has been awarded 16 national and regional awards including
“Southwest Account Executive of the Year – 2001”.

By Sean Harris

What is "Accounts Receivables Factoring"? Factoring involves the purchase of the face value of your accounts receivables or invoices by a factoring company at a small discount in exchange for an immediate cash advance, usually in the form of a wire transfer. Factoring accounts receivables, or "accounts receivables financing" as it is also known, provides billions of dollars in operational cash flow for companies each year. Once only used by a small group of industries, accounts receivable factoring is increasingly used by entrepreneurial-sized business who may have trouble securing loans from banks in today's fast paced economy. As banks step back, accounts receivable factoring is filling the financial void.

Why is "Accounts Receivables Factoring" important? Essentially, the use of a commercial finance company to factor your invoices is an off balance sheet transaction. This means that when you get beyond the need for financing you have no net term liability to be paid off. Each purchase of an invoice by the factoring company, when paid by the customer, is a completed business deal.

How is it done? The practice of factoring has been around for thousands of years. Whenever someone is owed money, there has always been someone else willing to take a cut of future income in exchange for providing "instant relief" to the owed party.
    The most common example of a modern receivable finance vehicle is the credit card. A merchant gets paid by the host bank before its customer gets around to paying the bill, and the bank takes a percentage of the customer's payment.
    The factor works in similar fashion, providing capital either by purchasing the asset value of a receivable (non-recourse) or by making a loan with the invoice as collateral (full-recourse). Some factors are private individuals with huge cash bankrolls, while others are public companies accountable to shareholders.
    When the factor purchases the value of the receivable, it takes the credit risk that the invoice will be paid, while the client retains the performance warranty on the work done for the customer. The factor usually performs a credit check on the customer before deciding to purchase the receivable. When a factor makes a loan against an invoice – which typically occurs when customer credit is not favorable – its client continues to assume the credit risk, and will be liable for non-payment.

How common is accounts receivable factoring? Since the factor often helps provide financial discipline for its clients, it isn't uncommon for a bank to recommend a factor to a client seeking a loan without the adequate credit record. Banks see factoring as an interim solution to inadequate credit. A few institutional banks offer accounts receivable financing directly.
     "Sometimes a company can't pursue conventional financing," says Michelle Douglas of Southern Financial Bank. "Factoring allows companies the opportunity to secure short-term working capital to get them in a better position to secure a banking relationship."
     An honest – and smart — factor wants its client to eventually graduate to conventional banking relationships. A company which cannot establish an exemplary credit history can eventually become a bad risk for any financial partner. The factor's ideal partnership is with a new or reorganized company with a bright future – one which probably won't include depending on a factor for more than limited time.

How does the perception of factoring affect a business that uses factoring? Until recently the use of a factor was thought to indicate that a company had fallen to the bottom of the financial pecking order. The perception of the factor as the last line in a shaky financial defense has persisted largely because of the unregulated status of the factoring industry.
     "The general misconception is that the only time to use a factor is when your company is going out of business" says Gary Honig, President of Creative Capital Associates. "Exactly opposite is the truth: Factors want to work with companies in a growth mode. They are as unlikely as any financial institution to invest in a failing company."

What has changed? The factoring industry is growing and has shaken out shady players through a combination of competition and the establishment of sound operating procedures. Factors watch each other closely and now provide assistance to one another much like banks do.
     Some factors specialize narrowly, dealing with just medical or construction receivables, for example. These factoring companies comprehensively learn their clients' business and industry. And while they often deal with companies unable to make a deal with conventional banks, the typical factoring company doesn't take on all comers. Far from it. Since it will operate as a de facto partner or investor by assuming the risk of a company's receivables, it's in the interest of the factoring company to take on clients who are growing, solvent, and ambitious.
     "It's critical to work with a factoring company who understands you and your business plan," says Gary Honig. "Most factors aren't willing to take on just anybody, and you should be wary of any factor who gives the impression that they're willing to do business with everybody. Normally, you shouldn't use a factor beyond the growth spurt that initiated the need for one. You should use a factor to get to better terms."

And terms, of course, vary greatly. The factor generally discounts the full face value of an invoice by a certain percentage. Rates are generally determined by risk and volume. High risk is more expensive; low risk less expensive. Low volume, measured in dollars per month financed, is more expensive; high volume less expensive. If a client can guarantee it will need factoring for a specific amount of either time or money, the rate is lowered. Some factors provide annual APR rates which are tied to the amount of financing outstanding, while others simply discount invoiced amounts between two to six percent.
     It's rare to find two factoring companies which operate entirely alike, partly because of the absence of regulation. Each factor has its own method to sort out credit issues, notify a client's customers, and verify that invoices are real and collectable. Some factors will also operate as a collection agency.

So what's the good news? Even skeptics admit that there factoring offers some unique benefits. First and foremost is retention of equity, which remains unchanged on the company balance sheet when a factoring arrangement is established. A conventional bank loan or credit line shows as an on-going liability on company books. Also, entering into a relationship with a factor – and getting capital – takes only a few days. For companies wrestling with a cash flow crunch, the immediacy of funding available through factoring is often the deal-maker.
     "We've been operational for over twelve years, and recently we got into a pinch due to some new and large accounts," notes Doug Beaver, owner of Gaithersburg-based Amguard Security Services. "Rather than going through a total re-application of our bank line, we used a factor for short-term working money until the new accounts became self-payable. Having never used a factor before, I was surprised how quick and painless the process was."
     But no aspect of the factoring business is as highly regarded as its flexibility. Compared with the usually rigid practices of both your neighborhood and downtown bank, a factor can be just the fresh opportunity a business needs to blossom.
    "Our business grew ten-fold in less than two years," says Anthony Wright of Virginia-based P&W Surplus Office Movers, "And factoring allowed us to sustain that kind of growth. It gave us flexibility."

by Sean Harris
[Mr. Harris has been widely published in newspapers worldwide (Washington Post, Baltimore Sun, Seattle Times, Montreal Gazette, Toronto Globe & Mail, London Times, Houston Post, etc.), and has written about information technology and DVD for a variety of national trade magazines (Information World, the SIGCAT Discourse. Etc.). He is the Creative Director for the PR and marketing company Pink Piglets Ltd., based in Washington D.C.]

When the vice president of a Reston high-tech firm arrived at his home office after a Las Vegas trade show, he was exuberant. The three-day show had been a smashing success, and he was looking forward to developing a solid roster of new clients from the product orders he'd received. But fulfilling these new orders meant more supplies needed to be purchased, employees would be working overtime, and shipping and handling costs were about to skyrocket.

The vice president actually had a dilemma on his hands despite his Vegas success. Instead of launching into a new level of sales, he would need to spend the next few weeks looking for capitalization while holding off expectant customers. The vice president turned to a little-known capitalization vehicle for help. Unable to borrow from a bank, he went to an entrepreneurial factor for the capital he needed. Using the completed Vegas orders as collateral, he quickly secured the cash needed to fulfill customer expectations. And as it turned out, fulfilling the Vegas orders led to the high-tech company being able to establish itself with a banking institution to avoid ever being short of capitalization again.

How is it done?

But what was the "entrepreneurial factor," and how common – and safe – is it to do business with this kind of finance provider?

The practice of factoring has literally been around for thousands of years. Whenever someone is owed money, there has always been someone else willing to take a cut of future income in exchange for providing "instant relief" to the owed party. The most common example of a modern receivable finance vehicle is the credit card. A merchant gets paid by the host bank before its customer gets around to paying the bill, and the bank takes a percentage of the customer's payment.

The factor works in similar fashion, providing capital either by purchasing the asset value of a receivable (non-recourse) or by making a loan with the invoice as collateral (full-recourse). When the factor purchases the value of the receivable, it takes the credit risk that the invoice will be paid, while the client retains the performance warranty on the work done for the customer. The factor usually performs a credit check on the customer before deciding to purchase the receivable. When a factor makes a loan against an invoice – which typically occurs when customer credit is not favorable – its client continues to assume the credit risk, and will be liable for non-payment.

How common a practice is this?

Since the factor often helps provide financial discipline and for its clients, it isn't uncommon for a bank to recommend a factor to a client seeking a loan without the adequate credit record. Banks see factoring as an interim solution to inadequate credit. And even institutional banks have begun to offer the kind of lending services normally associated with factors — accounts receivable financing.

"Sometimes a company can't pursue conventional financing," says Michelle Douglas of Southern Financial Bank. "Factoring allows companies the opportunity to secure short-term working capital to get them in a better position to secure a banking relationship."

An honest – and smart — factor wants its client to eventually graduate to conventional banking relationships. A company which cannot establish an exemplary credit history can eventually become a bad risk for any financial partner. The factor's ideal partnership would be with a new or reorganized company with a bright future – one which probably won't include depending on a factor for more than limited period.

How does the perception affect a business?

"The general misconception is that the only time to use a factor is when your company is going out of business" says Gary Honig, President of Creative Capital Associates, a Maryland-based factor. "Exactly opposite is the truth: Factors want to work with companies in a growth mode. They are as unlikely as any financial institution to invest in a failing company".

The perception of the factor as the last line in a shaky financial defense has persisted largely because of the unregulated status of the factoring industry. Some factors are private individuals with huge cash bankrolls, while others are public companies accountable to shareholders. Until recently the use of a factor was thought to indicate that a company had fallen to the bottom of the financial pecking order.

What has changed?

But the factoring industry itself is in a growth mode, and the marketplace is shaking out the shady players through a combination of competition and sound operating procedures. The factors watch each other closely – they interact constantly, providing assistance to one another as banks do – and they aren't shy about comprehensively learning their clients' business and industry. Some factors often specialize narrowly, dealing with just medical or construction receivables, for example. And while they often deal with companies unable to make a deal with conventional bankers, the typical factoring company doesn't take on all comers. Far from it. Since it will operate as a de facto partner or investor by assuming the risk of a company's receivables, it's in the interest of the factor to take on clients who are growing, solvent, and ambitious.

"It's critical to work with a factor who understands you and your business plan," says Honig. "Most factors aren't willing to take on just anybody, and you should be wary of any factor who gives the impression that they're willing to business with everybody. Normally, you shouldn't use a factor beyond the growth spurt that initiated the need for one. You use a factor to get to better terms."

And terms, of course, vary greatly.

The factor generally discounts the full face value of an invoice by a certain percentage. Rates are generally determined by risk and volume. High risk is more expensive, low risk less expensive. Low volume, measured in dollars per month financed, is more expensive, high volume less expensive. If a client can guarantee it will need factoring for a specific amount of either time or money, the rate can also be lowered. Some factors provide annual APR rates which are tied to the amount of financing outstanding, while others simply discount invoiced amounts between two to six percent.

Partly because of its unregulated nature, it is rare to find two factoring companies which operate entirely alike. Each factor has its own method to sort out credit issues, notify a client's customers, and verify that invoices are real and collectable. Some factors will also operate as a collection agency.

So what's the good news

Even hardcore skeptics of factoring admit there are some unique benefits to the practice. First and foremost is equity, which remains unchanged on the company balance sheet even when deals with a factor are struck. A conventional bank loan or credit line shows as an on-going liability on company books. Also, entering into a relationship with a factor – and getting capital — takes only a few days. For companies wrestling cash flow crunch, the immediacy of potential capital is often the deal-maker.

"We've been operational for over twelve years, and recently we got into a pinch due to some new and large accounts," notes Doug Beaver, owner of Gaithersburg-based Amguard Security Services. "Rather than going through a total re-application of our bank line, we used a factor for short-term working money until the new accounts became self-payable. Having never used a factor before, I was surprised how quick and painless the process was."

But no aspect of the factoring business is as highly regarded as its flexibility. Compared with the usually rigid practices of both your neighborhood and downtown bank, a factor can be just the fresh opportunity a business needs to blossom.

"Our business grew ten-fold in less than two years," says Anthony Wright of Virginia-based P&W Surplus Office Movers, "And factoring allowed us to sustain that kind of growth. It gave us flexibility."

By Sean Harris

Mr. Harris has been widely published in newspapers worldwide (Washington Post, Baltimore Sun, Seattle Times, Montreal Gazette, Toronto Globe & Mail, London Times, Houston Post, etc.), and has written about information technology and DVD for a variety of national trade magazines (Information World, the SIGCAT Discourse. Etc.). He is the Creative Director for the PR and marketing company Pink Piglets Ltd., based in Washington D.C.

Would financing be right for your business?
To find out click here!

At various times in the life of a company there are going to be requirements for outside assistance in order to grow the business. One requirement will be the need for additional capital. Choosing which financing vehicle is best for your company is very important. It's choosing the right tool to fix the problem.

Deciding whether to seek equity capital or debt financing is the first step. Usually companies trying to get equity capital are very early stage with little or no real assets. While companies on their way to a steady growth curve use debt financing.

The equity route

As the owner of a business idea, plan, or company – you hold ownership to a subjective value called equity. The equity of any type of property whether intellectual or physical is the value someone is willing to pay for it minus any liability attached to it. In business that could mean the value of an entity today measured in time and money invested versus the value in the future measured by comparable growth.

Once the owner and investor determine the "valuation" of the equity, the owner can then sell parts of the equity in order to raise capital. There are a variety of methods you can raise equity capital (Seed, Angel, Venture) and you should learn the pluses and minuses for each. An equity capitalist is interested in picking a company that shows great potential. They are expecting that there will be significant growth due to their involvement. That could mean that the company will grow tenfold within five years.

Without a doubt, first and foremost on any equity capitalist's due diligence list will be the management team. Even before the idea itself, it is commonly stated, great idea's with a bad team will get nowhere, whereas, bad idea's with a good team still have a chance to make it big. You should also realize, that once invested, the equity capitalist will be having an active role in the decision making of the company. Because they have "bought in" to your company they are now your partners, how active they become needs to be sorted out up front.

On the debt side

Conversely, raising capital through debt financing does not entail "selling" your equity, but instead works by "borrowing" against it. Debt financing is only available to business owners who have something of value that the lender can instantly liquidate. The debt finance company is not interested in becoming a partner in your endeavor, instead they are in business to make money from their money, letting you use it for periods of time.

Like equity financing there are a variety of methods available to raise debt financing. Traditional banking will always be the least costly source for your financing, but remember bankers are not in business to take on risk. When they ask for three years of company tax returns its because they want to see a steady reliable set of profitable growth numbers. Borrowing from the bank relies on two variables, the collateral that secures the loan, and your ability to repay the loan. You might have enough collateral, but if your business is losing money, the bank can't expect you to handle the added expense of loan payments.

Many early stage companies turn to private commercial financing which is better suited to deal with riskier issues. Factoring companies use the loans you make to customers (invoices for finished work) as the collateral for their funding. Here the emphasis will be the creditworthiness of your customers rather than the credit of your company. Equipment leasing companies will allow you to purchase new equipment and pay for it over time, usually three to five years.

Finally,

When seeking outside capital, whether equity or debt, remember that certain sources are familiar and like to work with particular industries. Take the time to look around and be sure that the source you are considering is well-aquatinted with your type of business.

- article appeared in the Business to Business Newspaper of Howard County & Columbia MD, May 1999.

 By: Daniel J. Borgia, Ph.D. Deanna O. Burgess, Ph.D.

Abstract

Growing firms often find themselves strapped for money. A gap in cash is created when bills are paid weeks before cash comes in from customers. The cash gap can be shortened by concentrating efforts on fast moving inventory, implementing a just-in-time inventory model, negotiating extended credit terms to suppliers, and getting cash out of customers through discount programs and credit card transactions. Only after exhausting these alternatives does factoring typically make sense.

Factoring provides quick access to cash through sales of receivables. The cash gap is shortened to the extent factoring brings in money earlier than receivables normally would. In general, firms that sell receivables immediately receive a percentage of the outstanding accounts sold. Once the receivables are paid, the factor forwards the balance of these collected accounts to the firm less a factoring fee. This article describes typical factoring arrangements and the costs/benefits of this form of financing. Fees can be high but may outweigh the costs of lost sales, ventures, opportunities, or at the extreme, going out of business.

A survey of small to medium sized businesses that use factoring provides a consumer profile of typical factoring arrangements. A majority of those surveyed are young, rapidly expanding organizations using factoring to support short-term entrepreneurial expansion efforts. Firms report that factoring typically provides access to seventy to ninety percent of cash tied up in receivables, with the balance provided within sixty to ninety days less a ten to twelve percent fee. In all, those that use factoring report high satisfaction, and often use the same factor on a repeat basis.  

Spending Money to Make Money

It’s not uncommon to hear about emerging companies that grow themselves right out of business. Cash demands often stall expansion efforts when bills are paid weeks before cash comes in from customers. Spending money to make money can be costly. The cash gap between payments deserves careful consideration. Rapidly expanding companies with excellent products and booming sales are hamstrung if receivables tie up cash needed to fund operations and growth. Understanding the factors that affect the time between payments affords a closer look at managing the cash gap and alternative financing options.

The Cash Gap

Managing the cash gap1 is illustrated in Exhibit 1. When a company pays its suppliers before it collects from its customers, the cash drain presents a financing need. The gap between payments is managed by getting cash out of inventory quickly all-the-while avoiding payment to suppliers as long as possible. Concentrating purchasing efforts on fast moving inventory, giving discounts to customers who pay early, and negotiating extended credit terms with suppliers all help to reduce the cash gap.  

Robbing Peter to Pay Paul

Small cash gaps are best. When inventory is purchased, sold, and collected in the same amount of time it takes to pay for the goods the cash gap closes to zero. Even better, a negative cash gap is a modern day version of robbing Peter to pay Paul. Customer Peter advances payment before the inventory is paid to Paul supplier. For example, customers of E-commerce companies like amazon.com forward credit card payments for books brought in on a just-in-time basis and paid for under thirty-day credit terms following the sale. Under this scenario, amazon.com maintains a negative thirty-day cash gap. Likewise, in the specialty cement business, customers pay for goods six to eight weeks before they are manufactured and shipped. In this case, the negative cash gap of forty to sixty days provides an internal source of financing.

To illustrate how the cash gap works refer to Exhibit Two. If a company spends an average of $10,000 per day on its operations, and it takes 100 days to convert its investment in the production process into cash (a 100day cash gap), then this firm will require roughly $1,000,000 in funding (on average) to support its operations ($10,000/day x 100 days). However, if this company can find a way to reduce its cash gap to say 50 days, then only $500,000 in funding is required. Finally, if we assume the cost of financing is 10% annually, this company could reduce its annual financing costs from $100,000 to $50,000 per year.  

Small Business Constraints

Unlike large, publicly traded firms, small businesses face a variety of operating and financial constraints that limit the extent to which they can close the cash gap. Many small firms face technological and managerial constraints that limit the ability to closely monitor (and hence reduce) inventory levels. Furthermore, small firms are more likely to lack the power that large corporations have in negotiating terms from suppliers. Finally, small businesses do not possess the same resources to devote toward the collection of accounts receivable. These small firms typically have limited access to short term financing alternatives to help short-term working capital needs. Obtaining working capital from banks can be difficult, time-consuming, and paper-intensive. Willing lenders are often hard to find.

Reducing the Cash Gap in Small Businesses

What options remain for small businesses interested in reducing the cash gap? One alternative is to turn the inventory/sales cycle upside down. Replicate the e-commerce model. Provide incentives for customers to pay cash upfront. Implement a just-in-time inventory system that affords the option of paying for inventory after the cash sale. In this way, the cash gap becomes negative.

A close second option that shortens the cash gap is to provide incentives for customers to charge their purchases using VISA or MasterCard. Credit card companies buy receivables for a one to five percent fee. If the customer factors (sells) the receivable by charging the purchase, little cost is involved, cash is obtained within days, and the cash gap shortens considerably. Cash discounts given to customers who pay early achieve a similar result.

Only when trade and industry expectations hamper efforts to accelerate customer payments should consideration be given to factoring existing receivables. Factoring receivables involves selling customer invoices to a third party at a discounted amount. Instant money is obtained without collateral or extensive corporate credit. The factor becomes the bill collector, assuming the majority of the risk of collecting payment.

The fee charged by the factor may be as high as five percent in the first month due to the lack of collateral or extensive credit review. Alternatively, if the receivables are sold with recourse, accomplished by a “validity guarantee,” the factor may charge a smaller fee in exchange for the right to hold the corporation liable for uncollected receivables. Limited time is spent underwriting the credit of the business and its customers, examining the track record of the business’ collection ability and the payment history of its customers. Audited financial statements are not obtained and the risk of fraudulent misrepresentation can amount to one-half to one percent of those factored. Understandably, many receivables are factored with recourse to mitigate the factor’s risk and the resulting fees imposed.  

Factoring Industry

The basic need for factoring originated from the practice of merchants extending beneficial “trade credit” to purchasers of their product or service — a concept that has been around for over 3,000 years. More specifically, the extension of credit occurs when a business sells merchandise to a purchaser, usually another business, but allows the purchaser time — usually 30, 60, or 90 days — in which to pay the bill. Unless the seller has sufficient funds in reserve during the “credit period,” continued production efforts are hampered.

Although factors have existed for thousands of years, the impact of high interest rates on businesses in the 1970’s generated renewed interest in factoring. Even after interest rates fell significantly, factoring continued to fill an ever-widening gap in the financial structure of our economy, especially with restricted bank financing. Because of the savings and loan debacle, lending institution loan portfolios are subject to greater scrutiny and stricter standards. As a result, the factoring industry has experienced rapid growth -increasing from $46 billion in factored receivables in 1993 to over $100 billion in 1995.  

The factoring industry can be divided into two broad groups that serve two distinctively different market segments. The first group consists of the factoring divisions of banks and other financial institutions such as Morgan Guarantee Trust Company, American Express, Citicorp, and Citibank, which provide receivables financing to their large corporate customers. These financial institutions will usually limit their purchases to $1,000,000 or more per invoice and charge relatively low fees — usually around 1 to 3 discount points. Numerous large Fortune 500 companies such as Western Digital, Honeywell, Georgia Pacific, and Scott Paper factor receivables through the factoring divisions of large financial institutions.

The second group of factors consists of small, privately owned financial services companies. These smaller factors generally fund new, rapidly growing companies that have exhausted their lines of credit and borrowing capacity at banks, and have few other working capital financing alternatives available to them. For these growth companies, factoring is an attractive means of raising capital. Small factors will purchase invoices as little as $1,000 or as much as $500,000.

Realistically, only those companies experiencing cash drains from growing sales typically utilize this type of financing strategy. However, struggling companies with cash flow problems also use factors in an attempt to increase cash flow. If a struggling company needs cash to begin turning its business around then this financing strategy may be effective. However, companies that are financially weak may have to sell their receivables at a greater discount than strong companies. Therefore, struggling companies often experience difficulty factoring in the long run. Also, factors will purchase only those receivables that they consider collectable. This means that companies with poorly managed receivables may find that factoring is not an option.  

Factoring

In a typical factoring arrangement, a business sells its accounts receivable to a factor at a discount, receives between 60% and 90% of the face amount of the invoice up front, and pays the factor between one percent and five percent of the face value of the invoice per 30 days. The balance of the receivable is remitted when the factor recovers its cash outlay. For example if ABC company sells a $10,000 receivable to a factor, ABC Company might receive $7,000 cash immediately (70%). At the end of thirty days, assuming ABC’s customer remits the balance to the factor, ABC will receive the remaining $2,500 less a 5% ($500) discount, which represents profit to the factor.

Factoring is a financing tool. The money can be used to purchase inventory needed for growing sales or perhaps to take advantage of supplier discounts by reducing payables early. Factoring also allows a company to increase its capital without taking on additional debt or selling more stock. Other benefits include improved credit ratings resulting from prompt debt repayment, internal cost savings by reducing the time and money committed to managing receivables which provides managers with more time to focus on growing the business. Companies that factor are often growing rapidly and have exhausted lines of credit and borrowing capacity at banks.

However, factoring has its drawbacks. Fees increase as the risk of noncollection escalates. Depending on the quality of the receivables, fees may reach five percent in the first month and higher in the weeks that follow. State usury laws regulating interest rate caps on borrowings, such as 18% in Florida or 24% in New York, do not apply. Factoring is considered a sale, not a loan. Factoring fees typically amount to ten to twelve percent on receivables paid within sixty to ninety days.

Despite the high fees, factoring benefits may outweigh the costs. For instance, losing out on 12% of the receivables to gain 88% immediately may be wise if cash is needed to accept a new contract promising repeat business or expansion into a new market that otherwise would have been forgone. For companies with strong receivables, losing out on 3% of receivables that typically take sixty days to collect may make sense if those receivables cost the company more than 3% in fees (interest, billing and collection) during the collection period.  

Exhibit Three illustrates the benefits of factoring. For a company with $1,800,000 in sales and $1,620,000 in operating costs, receivables that are collected every two months carry an average balance of $300,000. A moderate factoring fee may be assumed if the receivables are assumed to be high quality (i.e. government contracts) and take little time to be paid in full. Using factoring rates advertised by 21st Capital (www.21stcapital.com), the factoring fee is $27,000 or nine percent of the $300,000 receivables. Annualized, this fee amounts to $162,000, or nine percent of the $1,800,000 sales.  

Factoring fees may be offset by the interest saved by shortening the cash gap. The portion of the cash gap related to receivable collection, sixty days, is shortened to the extent that cash is received early. The annual interest saved is $21,600. The interest savings taken together with the savings in accounts receivable collection and billing functions estimated at $30,000 provides a net annual cash outflow from factoring of  $110,400 or 6.13% of sales. In this example, the benefits of factoring may outweigh the costs to the extent factoring brings in cash needed to fund additional projects or growth in excess of 6.13% of sales.

If the company is in desperate need of cash and factoring is ignored, a business may be forced to employ its last alternative — selling part of the business to outsiders. For many small business owners, selling part of a business may be difficult and an unacceptable alternative.

The Cost and Characteristics of Non-Bank Factoring Arrangements

A survey of smaller businesses utilizing accounts receivable factoring as a source of financing was conducted to assess the nature, costs, and characteristics of non-bank factoring arrangements. The survey was mailed in October 1999 to small businesses that used the services of factors within the past three years. The list and mailing addresses of businesses using factoring services was obtained from the client-lists of three Florida-based non-bank factors. The survey was designed to assist in creating a profile of businesses that utilize factoring. In addition, the survey explored the level of satisfaction businesses have with their factoring companies as well as the costs relative to other sources of short-term working capital financing. A total of 633 surveys were mailed and 59 were returned resulting in a response rate of 7.9%.  

Sample Firm Characteristics

Most of the respondents to this factoring survey (58%) have been in business for five years or less (see Exhibit Four). This appears to be consistent with the notion that startup firms with short track records and operating histories have difficulty getting bank financing and turn to factoring. When asked directly whether they had problems obtaining traditional bank financing, Exhibit Five shows that 64% of respondents reported they had approached three or more banks for lines of credit and 54% reported being rejected for bank financing three or more times. Only 9% of those surveyed reported they had not been turned down for a loan or line of credit at least once. In general, the responses suggest many small, young businesses that factor receivables are considered risky candidates for traditional financing sources.

Sample firms reported average sales levels of approximately $800,000 in 1996, $1,000,000 in 1997 and an $1,800,000 projection for 1998. A majority of these firms (64%) operate in a main facility that is less than 5,000 square feet, while thirty percent are housed in facilities 5,000-10,000 square feet and only six percent occupy spaces in excess of 10,000 sq. ft. Small businesses that factor have small facilities and are experiencing sales growth.

Consistent with an increasing sales trend, respondents report high expectations of growth (Exhibit Six). Nearly sixty percent of the respondents plan to add new products or services, forty eight percent expect to enter new markets, and thirty nine percent anticipate adding operating space to their facility. These businesses that factor fit a startup entrepreneurial profile.  

The Factoring Relationship

Given the drains on cash from sales growth, the respondents were asked how frequently they factor. The responses indicate factoring is used almost equally as a short term or long term financing alternative. One third of the firms reported using factoring less than six months, thirty-eight percent factored for six months to a year, and twenty-nine percent factored for more than a year. Most firms (83%) use one factor. Respondents in need of a factoring arrangement often do so repeatedly with the same financing source. As anticipated, Exhibit Seven illustrates that factoring serves a strong need for growing companies. A large number of firms report factoring kept them from bankruptcy (31%) or from turning down sales (39%).  

The benefits of factoring are evidenced in the survey results that indicate 60% of firms received an up front cash advance ranging from 70% to 90% of the value of the receivables factored (see Exhibit Eight). Less than five percent received over 90%. Surprisingly, nearly twenty percent of firms received less than 50% against the value of receivables.  

Factoring fees experienced by the respondents are provided in Exhibit Nine. While the largest percentage of surveyed firms paid two to two-and-one-half discount points per 30 days, this is still an  expensive source of capital. While there might be a tendency to view this fee on an annualized basis (2.5% for 30 days amounts to nearly 35% on a compound annualized basis), recall that typical fees are paid over two to three months on decreasing receivable balances. A compounded fee for the year at 35% would be incurred only in the unlikely scenario that the same receivable remains uncollected for twelve months with imposition of the 2.5% rate compounded monthly throughout that time.  

Despite the cost, a majority of firms appear to be quite satisfied with their factoring relationship. Seventy percent of the firms reported they were satisfied with their factoring relationship, while only 14% found this relationship to be unsatisfactory.  

Summary and Conclusions

Growing firms often find themselves strapped for cash. When bills are paid weeks before cash comes in from customers, the cash gap between payments represents a financing need. The cash gap can be shortened by concentrating efforts on fast moving inventory, implementing a just-in-time inventory model, negotiating extended credit terms to suppliers, and getting cash out of customers through discount programs and credit card transactions. Only after exhausting these alternatives does factoring typically make sense. Factoring provides quick access to cash through sales of receivables. The cash gap is shortened to the extent factoring brings in cash earlier than receivables normally would. This article describes typical factoring arrangements and the costs/benefits of this form of financing. Fees can be high but may outweigh the costs of lost sales, ventures, opportunities, or at the extreme, going out of business.

A survey of businesses that use factoring reports many are young, rapidly expanding companies using factoring as a short-term financing alternative. Factoring typically affords companies access to seventy to ninety percent of cash tied up in their receivables, with the balance provided within sixty to ninety days less a ten to twelve percent fee. In all, those that use factoring report high satisfaction, and often use the same factor on a repeat basis.

Daniel J. Borgia, Ph.D. Assistant Professor of Finance College of Business Florida Gulf Coast University 10501 FGCU Blvd. South Fort Myers, Florida 33965-6565 (941) 590-7371 dborgia@fgcu.edu

Deanna O. Burgess, Ph.D. Assistant Professor of Accounting College of Business Florida Gulf Coast University 10501 FGCU Blvd. South Fort Myers, Florida 33965-6565  

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