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Accounts Receivable Factoring- An Alternative to Bank Financing

Aug 17, 2007
Accounts receivable factoring may not be the world's oldest profession, but not far from it. This financial practice can be traced back to the Roman Empire. Invoice factoring was the dominant form of finance in the American colonies before the Revolution (mainly textile firms). Over the past few decades, consolidation has created two distinct types of factoring companies. Large, institutional-owned factors and several small,independent factoring firms dominate the industry.

Invoice factoring is the purchase of a business accounts receivable at a discount. Rather than wait 30 to 60 days or longer for the receivable to be paid, the factor purchases the invoice and advances most of the balance up front.

The client first completes an application, which includes a list of the receivables to be factored. The funding source then submits a proposal to the client, which includes an estimate of the factoring fee. If the client accepts the proposal, the next step is to pay a small due diligence fee. The factor must research not only the client, but more importantly, the credit standing of the debtors. After due diligence has been performed, the factoring company advances 70%-80% of the invoice balance to the client. When the customer pays the invoice (which is made directly to the factor), the client receives the remaining balance less the factor's fee.

(1) Growth: Consider this situation: You own a profitable, growing manufacturing company that has used up the credit lines the bank has extended you. A customer comes to you with a large order that needs to be filled soon. You must come up with the cash for production or forego the order to a competitor (which might cause you to lose the customer forever). Factoring existing receivables provides the financing for filling the order and increasing company profits.

(2) Survival: In this scenario, the company's cash flow is so tight that they must have the cash now to fund payroll, pay taxes, and meet expenses. They simply can't wait for a customer to pay the bill 45 days down the road. In this situation, factoring often becomes an ongoing relationship

A leading professional factor offers this illustrative story of a prospective client who owned a solid business with annual sales of $1 million and growing rapidly but in a continuing cash crunch. The business owner was shocked when he was offered a fairly typical credit factility.

The factor proposed to advance 80% of the value of the receivables, no recourse, for a 3 percent discount for the first 30 days. The balance would be paid to the customer upon payment of the bill less the discount. What upset the business owner, who said he was operating in a very competitive market, was the 3 percent rate. "If I raise my prices 3 percent, I'll go out of business", he said heatedly. The factor's response was to assure him that in all likelihood, he wouldn't have to raise his prices at all. He then asked a simple question: "How much business could you do if you had unlimited funds available?" The owner's reply was "I could easily increase sales to $2 million."

Here are some facts about the business: The firm made $90,000 on $1 million in sales. If all accounts receivable were factored, the annual cost for the immediately available cash would be $30,000 and administrative overhead would increase by $20,000. However the cash infusion would allow sales to zoom to $2 million. After reviewing the following profit comparison, the business owner realized that he was able to double his profits without incurring any debt. In addition, he didn't have to dump any more of his own money into expansion of the business. The factoring fee was no longer an issue for him.

Present With Factoring
Annual Sales $1,000,000--$2,000,000
15% Gross profit $150,000--$300,000
Overhead Cost $60,000--$80,000
Factoring Cost * N/A $30,000
Net Profit $ 90,000--$180,000
* Based on the incremental $1,000,000 sales factored

1. Elimination of bad debt - a non-recourse factor will assume the risk of bad debt, thus eliminating this expense from your income statement.

2. Professional collections - Not only will a good factor collect receivables in a professional manner, but he will eliminate overhead associated with the collection process.

3. Unlimited capital - Factoring is the only source of financing that grows with your sales. As sales ncrease, more cash becomes available for you to use, which allows you to constantly meet demand.

4. Take advantage of volume and early payment discounts - With improved cash flow, you will be in a position to take advantage of these discounts which directly effect the bottom line.

5. No debt incurred - Factoring is NOT a loan and therefore, you are not incurring any debt. This keeps your balance sheet looking good, thereby making it easier to obtain other types of financing or to sell the company.

6. Factoring is easy and fast - The application required to establish a factoring relationship is much simpler than other types of financing. No tax returns, financial statements, business plans, or projections are needed.

7. No personal guarantees. The company principals do not have to personally guarantee the repayment of the funding. They usually have to guarantee against fraud or disputes, but not against customers' inability to pay.

8. Invoices are paid faster - Factors generally report payment experiences to Dun & Bradstreet or other credit agencies. A debtor who is aware of this will not want his credit impaired.

9. Credit screening - A factor will provide you with credit information on new customers, thus allowing you to make better credit decisions.

Accounts receivable factoring may not be for everyone. But those who are in the role of "banker" for their customers should at least take the time to weigh the benefits of factoring to provide continued growth and stability.

Invoice factoring continues to be a popular financing tool, particularly among the textile industry. Other industry sectors, such as distributors and manufacturers, are beginning to take advantage of this option as well.
About the Author
Kent Harlan has been a CPA since 1984 and is the owner of Ozarks Capital Funding, a firm offering financing in the areas of accounts receivable factoring, equipment leasing , and financing for healthcare providers .
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