Accounts Receivable Factoring

Factoring may not be the world’s oldest profession, but not far from it. This financial practice can be traced back to theRoman Empire. 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 funding sources (called factors): large, institutional-owned factors and several small, independent factoring firms.

What Is Factoring?

Factoring is the purchase of a business accounts receivable at a discount. Rather than wait 30, 45, 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 factor fee. If the client accepts the proposal, the next step is to submit a check for due diligence. The factor must research not only the client, but more importantly, the credit standing of the debtors. After due diligence has been performed, the factor 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.

Why Do Companies Factor?

(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.

How Can Factoring Increase Profits?

Here is an example of how factoring work:

A prospective client who owns a solid business with annual sales of $1 million and is growing rapidly is in a continuing cash crunch. The business owner was shocked when offered a fairly typical funding arrangement in which the factor proposed to advance 70% of the value of the receivables, no recourse, for a 4 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 4 percent discount. “If I raise my prices 4 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 A/R were factored, immediately available cash would be $40,000
  • 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 without having to dump any more of his own money into expansion of the business, and after paying the factor. The 4 percent factor fee was no longer an issue for him.

 

Factoring Profit Comparison

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

$40,000
Net Profit

$ 90,000

$180,000

* Based on the incremental $1,000,000 sales factored

Share your stories if you’ve used factoring for your business. While everyone cannot get this kind of result by factoring you’d be surprised at what freeing up additional cash can do for your business.  If you’d like to see if this can work for your business contact me or you ca find more information on our website.