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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. 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?
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 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 accounts receivable were factored, the annual cost for the immediately available cash would be $40,000 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 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.

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
WHAT OTHER BENEFITS ARE THERE TO FACTORING?
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 increase, 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.
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.

Accounts receivable 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.

Kent Harlan has been a CPA since 1984 and has provided consulting, accounting and financial services to several industries. He is the owner of Ozarks Capital Funding, LLC, a Springfield, MO based company offering financing in the areas of accounts receivable factoring, equipment leasing, asset based lending, and healthcare provider financing. Website: www.ocflink.com

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