Factoring and the financing of receivables

The accounts receivable on the books of your firm are an asset. The larger the receivables, the more working capital financing the firm requires. One way of reducing this need for capital financing is by selling the receivables or by using them directly as security for obtaining capital. Often, receivables form part of the basis on which banks calculate the lending limit of an operating loan.

Banks often use accounts receivable as the basis for operating loans and will advance 65-75% of the value of the receivables. Such loans cost between prime and prime plus three percent. Alternatively, the firm can raise cash by selling receivables that it has not pledged as security for a loan. Factoring is the process by which the firm sells its accounts receivable. Factors are specialized finance companies that work with businesses in two ways. They provide financing and services.

When a factor provides financing, the firm and the factor contract to undertake a continuous process. As the business receives orders, the factor:

• evaluates the creditworthiness of the customer and approves (or not) the extension of credit.
• advances 80 to 90% of the invoiced amount to the business; the amount retained by the factor provides for a reserve for contingencies such as rejection of the goods by the buyer. The factor usually remits the balance to the business once they collect the account.
• assumes the risk of collecting on the receivable.

This traditional form of factoring provides the firm with both financing and services. Firms can also contract with factors on a services-only basis.

Factoring firms offer a range of services. These include acting as the small business credit department by carrying out credit assessments, making the credit decisions, and assuming the risk of bad debts for all receivables. When the client firm sells its product, it sends a copy of the invoice to the factoring company. The factoring firm takes on the responsibility of collecting the account. Unlike traditional factoring, small businesses retains title to the receivable, and can pledge them to a lender if desired. The factor can also handle paperwork and provides reports to the client. Factoring firms offer credit guarantees and will buy, sometimes at full value, clients' overdue receivables.

Factors charge fees that average one to two percent of the gross value of the accounts receivable for both services and guarantees. These fees vary by business size and industry sector, with smaller firms generally paying rates at the higher end of the range, but fees can mount up if the firm is not paid the receivables when due. For overdue accounts, the cost of factoring is approximately one percent of sales-per month. This fee level is significant, particularly for low margin businesses. However, fees can still compare favourably with the internal cost of maintaining a credit department.

While factoring was historically centred in the garment trade in Montreal, it is now common in such industries as consumer electronics, furniture, sporting goods, and automotive aftermarkets. Recent deregulations of the financial services industry includes provisions that allow banks to act as factors. Factoring is therefore becoming more common and is likely to expand further.