Factoring accounts receivable is a form of short-term borrowing. Typically, you transfer all or a portion of your accounts receivable to a bank or other lender known as a factor. The factor immediately gives you a percentage of your accounts receivable. The percentage the lender is willing to advance is known as the discount rate and is typically 60 to 80 percent. This money allows you to fund current business operations and generate new accounts receivable. Typically, the factor takes responsibility for collecting the accounts receivable. Your customers make payments to a lockbox (in general, this is a post office box). Under some factoring agreements, the factor will pay you additional amounts if and when your accounts receivable are collected (these are called residuals).
Factoring is referred to as a form of short-term borrowing, but your company can operate under a factoring agreement indefinitely. Each month, you factor a new set of accounts receivable. Although the relationship is long-term, each transaction is really a short-term loan whereby the lender advances funds to you and is typically repaid over a period of 30 to 120 days as your accounts receivable are collected.
When should you use it?
Businesses typically enter into factoring arrangements to solve cash flow problems. Your business provides goods and/or services for buyers, to whom you forward invoices, that might not be due and payable for 90 days. Even then, the payments might come in late. In the meantime, you need to buy new supplies, meet payroll, and service current debts. You have plenty of assets on paper but no readily available cash. Essentially, you have a cash flow problem. Enter the factor, which turns your accounts receivable into instant money. You pay a premium for the loan, but, without it, you could run into more expensive problems.
What are the strengths associated with factoring?
Provides you with immediate cash flow
The biggest strength of a factoring agreement is that it turns your accounts receivable into instant cash. If you are having cash flow problems, this can be your solution.
May eliminate collection expense and hassles
Most factors undertake collection of your accounts receivable themselves. They may have large automated departments that specialize in collections. This means you can devote more of your time and money to generating new accounts receivable, and less of your time and money to collecting old ones.
Caution: Some factors charge a fee for collection of accounts that are over a certain number of days old. If one of your customers fails to pay as agreed, the factor may do the legwork to collect the debt, but you have to pay an additional fee.
Factors are willing to lend money against accounts receivable
Factors specialize in a type of lending that most other lenders avoid. Most lenders won’t make loans secured solely by accounts receivable, since the value of accounts receivable can be difficult to quantify. As invoices are paid and new invoices generated, the value is always changing. Unless the lender examines your books on a daily basis, it will never really know how much collateral it has or whether the loan is secured at all.
Further, when a lender lends money on the strength of accounts receivable alone, it is not only relying on your creditworthiness but also on the creditworthiness of each of your customers. The more customers you have, the more difficult it is to calculate the likely return, which means greater risk. If the lender will make the loan at all, it will likely want additional security or guarantees.
Accounts receivable may be sold without recourse
Typically, accounts receivable are transferred to the factor without recourse. This means that the factor, not you, bears the risk of loss if the account becomes uncollectible.
Caution: If a factoring agreement is without recourse, then it will likely have a lower discount rate. This means you pay more for the loans (i.e., you will receive a smaller percentage of the accounts receivable that you transfer to the factor). If the factoring agreement is with recourse, then you will likely have a higher discount rate. You will get a larger percentage of the accounts receivable, but if any of your customers fails to pay, you have to compensate the factor for any balance that was uncollectible.
Tip: Some factors will allow you to replace (trade) an uncollectible account with a collectible account. This eliminates the need to come up with a cash payment for the factor, but leaves you with a loss all the same.
You may be able to collect residuals
When you transfer your accounts receivable to a factor, you immediately receive a lump sum of cash, the amount of which is based on your discount rate. In some cases, this is all you will ever get. However, some factors will pay additional amounts to you if and when the accounts receivable are collected. These additional amounts are called residuals.
For instance, your agreement could provide that if the factor is able to collect all of your receivables within 30 days, then you will get an additional 10 percent in residual payments. It might also provide that if the factor collects all of your receivables within 60 days, then you will get an additional 5 percent. If it takes more than 90 days to collect your receivables, then you get nothing. In this way, you and the factor share the gains and losses associated with collections.
Caution: Pay careful attention to the wording of the contract and consult your attorney. The factor can use a number of methods for determining your right to residuals. For instance, it may base your right to receive residuals either on the average amount of time it took to collect each receivable in a group, or on the total amount of time it took to collect all of the receivables in a group. The latter is almost always a longer period of time than the former, and the longer the time period, the lower the residuals. One small, slow-paying account could mean that you get nothing beyond your original advance.
What are the tradeoffs of factoring accounts receivable?
High effective interest rate
Because lending on the strength of accounts receivable is risky, you will pay a premium for the money you borrow. Factors talk in terms of discount rates. However, you can calculate an effective interest rate using a financial calculator.
Example(s): Each month, Joe places $100,000 worth of accounts receivable with a factor. Under his factoring agreement, Joe has an 80 percent discount rate, with no residuals. On average, the factor is able to collect Joe’s accounts receivable within 90 days. In effect, Joe is paying $20,000 to borrow $80,000 for three months. His effective annual interest rate exceeds 92 percent.
Tip: All too often, business owners are shocked to find out how much they are really paying to borrow from a factor. Before you enter into an agreement, have an accountant or financial advisor calculate the effective interest rate you will be paying. If for no other reason, it will be useful when comparison shopping.
Factors may not accept all of your accounts receivable
Some factoring agreements allow the factor to reject certain accounts. The factor may require that you provide a payment history for each account and will then select which accounts it is willing to take. Typically, the factor will reject any accounts that are habitually slow paying. In effect, they skim the cream. This leaves them with less risk but leaves you with bad accounts to collect yourself.
Factors may demand a minimum monthly placement
Most factoring agreements are for a period of a year or more. During that year, your agreement may obligate you to transfer to the factor a minimum number of accounts receivable each month. If sales drop off and you have insufficient accounts receivable, or if the factor rejects the accounts you have, you could be penalized. Don’t sign a contract unless you are sure you can perform and you have consulted your attorney.
Factors may charge you for their costs
Some factors deduct their costs from your advances and/or residuals. For example, the costs they incur in hiring an attorney to draft and review the factoring agreement may be charged to you. Various costs associated with collection, including legal fees, may be charged to you. Costs associated with conducting an audit of your books and records may be charged to you. Costs of investigating and resolving any of your disputes may be charged to you. Many costs that you might think should be a part of the factor’s overhead might be charged to you. Therefore, read the contract carefully and have an attorney review it. Make sure you know what expenses you are incurring so that you can use the numbers when calculating your effective interest rate.
Factors may charge a security deposit
Factors may hold back a portion of your initial advance to serve as a security deposit. This provides the factor with a financial cushion if you are unable to perform under any portion of the agreement.
Factors may require other security
Factors may require that you grant a blanket security interest in all of your business assets to secure your performance under the factoring agreement. They may also require personal guarantees. How much security they require will vary depending on how much risk they anticipate.
Unscrupulous factors can take advantage of distressed business owners
Most factors are reputable lenders who enter into financial arrangements that are mutually beneficial to all parties involved. They form long-standing business relationships with companies who regularly factor their accounts receivable. Without factors, industries such as the garment industry and the furniture industry would face significant difficulties.
However, there is a class of factor that seeks out distressed business owners. This class of factor is not looking for repeat business or referrals. It is looking to make as much as it can and as quickly as it can. The typical target is the closely held company that is facing a cash flow crisis. This company has no previous experience with factoring agreements and has plenty of accounts receivable, but doesn’t have enough cash to hold out until it can collect them. The mortgage is overdue now. The payroll is due on Friday. The IRS is knocking on the door. The company doesn’t want to lay off employees, and it has to buy more supplies to keep the production line running. The company is vulnerable. In these situations, the business owner is unable to bargain from a position of strength. The factor presents a solution, and the business owner grabs at it out of desperation. The business may be so cash poor that it doesn’t even choose to hire an attorney to review the contract. Later, the business owner comes to realize that he or she has made the most expensive business decision of his or her life. Avoid putting yourself in this situation.
How can you protect yourself?
Factoring can be an expensive way to borrow money, but you will undoubtedly do better if you follow a few simple rules:
- Try to anticipate cash flow problems so that you can avoid them, arrange for other borrowing, or at least have time to negotiate a factoring agreement from a position of strength before you become desperate for the money.
- Shop for factors. Don’t take the first deal offered to you without checking out what the competition has to offer. Seek referrals and information from other companies who use factors.
- Always seek the advice of an attorney before entering into a factoring agreement. Try to find an attorney who has experience with factoring agreements.
- Understand the true cost of borrowing from a factor and compare it with your alternatives.
