Factoring: What Is It?
 

Factoring is the selling of accounts receivable by the business holding them (in order to obtain cash payment of the accounts before their actual due date) to a specialized agency known as a Factor. Factoring differs from borrowing, in that the accounts receivable are actually sold rather than merely offered as collateral.

 

Essentially, there are two types of factoring: recourse and non-recourse.

 

Ø      In Non-Recourse Factoring, once the Factor has purchased the receivable, the risk of loss due to an insolvency / bankruptcy on the part of the Seller's client (the Debtor account) is no longer with the Seller but becomes the risk of the Factor.

 

Ø      In Recourse Factoring, if a debtor account does not pay his invoice, the Factor can go back to the Seller for payment. Because the credit risk ultimately stays with the Seller in recourse factoring, rates of interest charged to the Seller are governed by the usury laws of the state in which the transaction takes place.

 
Factors buy "performing invoices."  Performing invoices defined as:

1. Having not reached the terms set on the invoice.
   
2. Will be paid within an agreed-upon time period usually  90 days).

 

The only exception is if the time period is breached due to the bankruptcy of the debtor, then the seller keeps the advance and the factor is responsible for getting paid in bankruptcy court.

 

 

Assess the Costs By Looking at the Benefits.

 

Too often potential clients will begin the factoring decision by looking at factoring discounts (percentages) on an annualized basis, like a car loan or a mortgage.

They take the 3% they are quoted, annualize it (multiply by 12) and respond with "you are going to charge me 36% interest!" At first, that may seem like a factual, pertinent statement. However, we deal in short-term funding, an average invoice pays in 42 days.

When they respond that it is still "36% interest" we ask them to look at the 2% they offer for quick payment. That 2% discount is for payment in 10 days. In a year there are thirty-six 10-day periods--------using the annualized percentage parallel, "that's 72% interest! Are they paying 72% for quick payment? No, and factors don't earn 36% for funding, either.

Why? Because factoring is short-term paper. To compare it to a long-term note is like comparing apples to oranges. In the end, the decision to factor always comes down to a business decision. If this money is going to cost 3%, can you take the money generated by factoring and earn more than 3%? After all, nobody factors just to have the money in their checking account.

Most businesses must weigh the costs of factoring against the costs of not doing it. Most often the decision is between factoring and putting up with cash flow problems.

If you are missing out on sales opportunities because of a lack of cash flow, be sure to consider that lost revenue when weighing the costs of factoring. Consider what increases in profits you can achieve with additional cash flow.

For example, if in your current situation, without factoring, you have gross revenues of $100,000 a month. Your cost of goods is 65% resulting in gross profits of $35,000. Subtract overhead at 32% ($32,000) and you are left with a net profit of $3,000.

Now, consider what additional cash flow would enable you to do, such as take additional discounts for volume purchases, increase your sales and advertising effort, or add a second shift. By factoring the first $100,000 in receivables, you can project a doubling of revenue to $200,000 with a consistent 65% cost of goods (although this may actually come down depending on if you can receive discounts for paying in cash). This puts your gross profit at $70,000. Subtract overhead of $44,000 (which is more, but never double) and the cost of factoring----$6,000----and you are looking at a net profit of $20,000.

So how expensive is factoring?

In this instance, which is more than typical than not, the decision not to factor would have cost you $20,000 in missed opportunity for one month. So how expensive is factoring?

To accurately figure your profit margin with factoring, you must take into consideration the full spectrum of services offered. This is especially true if you are comparing factoring to borrowing then you are probably on sound ground. If you are looking to use the proceeds of factoring to pay overhead, to clean up bad debts, to pay past due cost-of -goods invoices, then you need to look carefully at what you are doing. Will this increase your chances of growing and expanding?

It is rare that companies decide not to factor because they could not afford to. As a matter of fact, in most cases, companies decide to factor because they can't afford not to.


Why Receivables Funding is more appropriate than bank financing:
    

• Is based ONLY on the Accounts Receivable. A client's ability to raise cash by Receivables Funding is based on the total accounts receivable, rather than on traditional measures of financial strength and stability.  
• Provides continuing cash flow without the requirement of periodic payments or interim payoffs. New sales continuously create new power to obtain cash, and the business does not have to deal with renewal of loans or worry about maturity dates.  
• Gives a business increased access to cash as sales and receivables increase. There is no ceiling beyond which the factor must stop providing cash. The more sales a business makes, the more cash it can draw. The factor does not concentrate on the business debt/equity ratio to provide funds, as banks do.  
• Offers a dependable, continuing source of cash without the necessity of making separate loan applications.
• Avoids the necessity of obtaining funds from venture capitalists, which receive an interest in the business and generally have a say in how the business is run.
• Saves the business owner precious time waiting for a loan board to grant or deny his or her loan. Loan boards' decisions are influenced by many considerations, and the outcome is often unpredictable.
• With factoring, periodic delays and negotiations are eliminated, allowing the business owner time to do what he or she does best – run the business.

How Factoring differs from banking.

Comparing Bank Lending Rates to Factoring?
When compared to bank lending rates, factoring initially appears to be very expensive. Here are a few typical questions/concerns that we hear from potential clients.

* Wow! 3 points per month! That's 36 percent year!

It is tempting to annualize the numbers, but that is an "apples and oranges" comparison. Banks loan money at an annualized interest rate, 12 percent per year for example. Factors purchase your receivables at a discount. The products are different and there are other inconsistencies to this inappropriate comparison

A bank provides the money only one time, the day that you receive the loan; factors provide money continuously. As an example, consider a bank loan for $100,000 at 12 percent. You receive the $100,000 just one time and then pay $1,000 interest per month interest and you still owe the $100,000. Or the bank could provide you with a line of credit that you use only when you need the money but the bank is charging you for that privilege and continue to charge until the credit line is paid off.  You may be paying interest on a purchase for months and maybe years.  *Also, if you need to increase your line you need to go through the qualifying process all over again.

When you factor $100,000 each month for a year you have the use of $1.2 million (12 x $100,000) over the year. Unlike a bank loan, where you have just $100,000 one time. Assuming a 3-point discount, the fees over the year will be 12 x $3,000 or $36,000, which is still 3 percent of $1.2 million. And at the end of the year you have no debt!

* I'm only making 3% profit, how can I pay you 3 points?

A company making only 3% net profit can do more business volume as a result of factoring, and the larger volume will result in a higher profit margin because fixed costs do not increase with volume. The added business at a higher marginal profit leads to an increased overall profit margin. As the volume increases, the cost of production decreases, so that profits increase. Fixed costs i.e., rent, electric, insurance, etc., increase very little or not at all with volume. An increase in business will not affect rent. Electric bills may rise slightly. Workers compensation insurance may rise slightly. These costs do not increase as do direct production costs.

Let's graphically do the math assuming you can double your sales.

                              Without Factoring           With Factoring

Monthly Gross Sales	$50,000	Monthly Gross Sales	$100,000
Cost of Goods Sold	$30,000 60% of Gross Sales	Cost of Goods Sold	$60,000 60% of Gross Sales
Monthly Gross Profit	$20,000 40% of Gross Sales	Monthly Gross Profit	$40,000 40% of Gross Sales
Fixed Expenses	$10,000	Fixed Expenses	$10,000
Variable Expenses	$8,500 17% of Gross sales	Variable Expenses	$17,000 17% of Gross Sales
Factoring Fee	N/A	Factoring Fee	$3,000 3% Fee
Total Expenses	$18,500 37% of Gross Sales	Total Expenses	$30,000 30% of Gross Sales
Monthly Net Profit	$1,500 3% of Gross Sales	Monthly Net Profit	$10,000 10% of Gross Sales

* But I only get 80% of my money upfront!

Let's assume an advance rate of 80%. Let's also assume that you begin factoring in January. You have factored $100,000, a factor pays you $80,000 of that money upfront, with the remaining money making up the fee (3%) of $3,000 and the reserve (17%) of $17,000.

Now in February, you once again factor $100,000 and receive $80,000. However. you also receive your January reserve of $17,000(assuming your customer pay in 30 days). So for February, you actually receive 97% of your money, instead of 80%. In the second month and going forward you are basically receiving 97% of your cash flow.


* But what if my customers take longer than 30 days to pay?

You have several options; Assume your client takes 60 days to pay. You bill your client in the normal fashion and simply allow 30 days to go by prior to factoring that invoice. That way you pay the 30-day fee. Another way is to factor your faster customers first for the cash you need.

 

10 Benefits of Factoring

1.  No additional debt. Factoring is not a loan and therefore the business is not incurring any additional

2   Unlimited working capital. Factoring is the only source of financing that grows with sales. As sales increase, more money becomes immediately available. This allows the business to constantly be able to meet increasing demand.

3. More efficient staff.  With a rapidly growing business, outsourcing credit collection and management to a specialist organization will save staff costs, management time, operating / collection costs and reduce bad debts.

4.  Reduced banking charges.  Because the business only receives wire transfers or the checks received from the Factor, the number of checks deposited will be lower. This results in reduced banking charges.

5.  Interest (or discount) charges are only applied to funds advanced.  Bank loans charge interest on the entire amount, even the portion of funds not being used at that time. .

6.  Set your own payment schedule. A company that factors will set its own payment schedule.  By having unlimited working capital a company can pay its debts immediately and not have to wait until they are paid by customers.

 7.  Asset Protection.  The receivables have been sold; therefore they are not an asset that could be lost in a litigation settlement.

8.   Invoice processing. Factors handle much of the work associated with processing invoices, including posting invoices to a computer system, depositing checks, entering payments in the computer and produce regular cash flow reports. 

9.  Take advantage of early payment discounts and volume discounts. If a business can save 2 – 5% of their raw materials cost because they have the cash to pay within ten days, this significantly reduces the true cost of factoring.

10.  Retain equity. The business owner does not have to give up any equity in the company (as is usually required with venture capital) or take on any partner with factoring.

 

Is Factoring For You?

The key to knowing if factoring is for you is to not to look only at the bottom-line factoring fee, but also to consider how your company may increase its profits through factoring. Here is additional information on factoring to help you with your decision.

How are fees and advance rates determined?
It is based on several factors:

• The credit worthiness of your clients.
• Your monthly billing volume.
• Average invoice amount.
• Average days to payment.
  
  Fees can range from 2-6 % of the invoice's face value. For example if the invoice's value is $1,000; a fee of 3% equals $30.

What is an advance?
The amount of money you receive immediately when we buy your invoice. The balance is returned to you when your customer pays the invoice.

Advances range from 60-95% of the invoice's face value. For example if the invoice's value is $1,000 an advance rate of 80% equals $800. The balance of $200 less the factoring fee is returned to you when your customer pays the invoice.

 

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