Factoring: A sellers guide.
An overview to factoring receivables -- faster money after a sale.
Usually, we call these "buyer's guides," but when you're factoring your receivables, you're not buying. You're selling. Specifically, you are selling your receivables to a third-party who, in turn, immediately pays you a price that is discounted from the face value of the receivable.
This guide will address the most common questions customers have about factoring services, including
The practice of factoring has been around for thousands of years and goes by many names – invoice discounting, accounts receivable factoring, receivables financing and debtor financing. It is popular with companies who serve the healthcare, transportation and manufacturing verticals. However, it can be used by any qualifying company that can improve its profitability by accelerating its cash flow.
For example, let’s suppose you’ve sold a crate of goods to someone on credit with 30 days (net 30) to pay the bill. The common challenge lies in that your suppliers may need to be paid quicker than your client will be paying you. See the example below.
Figure 1 - Typical Cash Flow Shortage Scenario
The challenge lies in that during the “Cash Shortage” a company may delay serving other customers due to the inability to purchase additional raw materials and/or labor.
However by using factoring, you can turn over that customer’s 30-day invoice to a financier, called a factor, who will pay you most of the debt’s face value.
Figure 2 - Cash Flow with Factoring
Now you have cash in hand for the goods. Your customer owes the factor, not you. And you no longer have any financial risk associated with the transaction. (Recourse factoring can change that, however. More about that later.)
In one sense, invoice factoring is a type of outsourcing. Another company collects your receivables for a fee, paying you at the time of transaction. Unlike other funding options like a line of credit or loan, factoring doesn’t show up as a liability on your balance sheet. Depending on your industry, sales practices, and cash flow situation, factoring may be the solution for getting the most out of your cash flow. For other businesses, there may be other financing options available.
In this guide, we'll explain when to factor your receivables, and when you should look to other solutions.
Who should consider factoring their receivables?
Before deciding whether factoring is right for your business, here are several items to consider:
Access to working capital: Factoring is a way of reducing your working capital requirements -- the amount of money your business has tied up in inventory and accounts receivable, less your own payable accounts. With factoring, as with any financial service, you should compare the costs to make sure this is the best option.
Your firm's size and time in business: Factors tend to be more willing to finance smaller companies and startups than banks. Most require at least $500,000 a year in accounts receivable to factor at a reasonable rate, although firms with as little as $10,000 a month will find services available. If your volume is less than that, a corporate credit card may better fit your needs.
While flexible in their underwriting and qualification standards, factors will expect to see a track record of stable or increasing receivables along with a client payment history that aligns with your industry standards, so that they can judge the quality of the invoices they will be purchasing. To get the most favorable terms, your business needs to have at least two years of receivables history.
When your receivables start to exceed $20 million a year, traditional lenders may become more interested in your business, especially if it's simply to fund working capital needs.
Your clients: When a bank considers lending money, it looks at the operations of the company and the credit quality of the debtor. But when a factor considers purchasing invoices, it's not looking at your credit quality as much as it’s looking at the credit quality of your customers. Remember, it’s your customers’ ability to pay the invoices that makes this program work. Typically some of your clients will have a higher credit rating, others will have lower. While it may tempting to only send the lower quality invoices to the factor, the factor will require that you send all of the invoices to help balance and manage the risk.
While factoring offers multiple advantages, it does not always mitigate collection risk. When the client doesn’t pay their invoice, most often the factor will turn back to your business to cover the loss. This is called recourse factoring. Nonrecourse factoring – a sale of an invoice without allowing the factor to sell it back to its client – eliminates this collection risk, but at a higher premium. You and your factor will have to decide on recourse or nonrecourse terms in your contract.
Your profit margin: Your profit margin needs to robust enough to cover the costs associated with the factoring. You should be able to demonstrate a 30% margin at minimum.
Your cash conversion cycle: See our example in the overview.
Operational efficiencies: A financial analysis of factoring will reflect the additional costs associated with the program and the impact on operating margin. This impact can be offset if a shorter cash cycle allows you to improve your operating efficiency, by eliminating idle time in manufacturing, receiving volume pricing for raw materials, or achieving discounts from suppliers for shorter payment terms.
Opportunity costs: Sometimes, a faster cash cycle might also eliminate an opportunity cost associated with a lack of capacity.
How it works
Figure 3 - Cash flow of a factoring transaction
The application process for factoring is, as expected, fairly robust. Still, it can be completed within a few business days. Typically once a factor receives your application, it will immediately start a credit check on your account receivables.
Because of the labor and costs associated with evaluating your account, most factors charge an application fee that ranges from $300 to $1,000. Application fees that are near or exceed $1,000 without a legitimate explanation should be considered a red flag.
Unlike a bank loan, in which the debtor’s financial viability is the only consideration in acceptance, factors have to take into account both your credit worthiness as well as the worthiness of your clients.
Items typically required by a factor include:
· Balance Sheet
· Profit/Loss Statement
· A/R History, Average Age, Collection Rates, etc.
· Details related to your top customers
As we mentioned earlier, the factor is scrutinizing your client’s ability to pay as well as your credit worthiness. Interestingly enough, one of the reasons that your application could be rejected from a factor is if one of your major clients already owes an excessive amount to the factor from doing business with one of your competitors.
While both CIT Group and Wells Fargo handle a great deal of factoring volume across multiple industries, some industries, such as healthcare, tend to have specialized factors serving clients. As such, if you are talking to a factor that specializes in your industry, it’s likely to know as much or more about the payment trends in your industry as you do.
If you are accepted into a factoring program:
· You and the factor will negotiate pricing (see below)
· The factor will then send a "notice of assignment" to your customers, legally notifying your customers that their payments should be sent to the factor and not to you.
· The factors will establish a lockbox arrangement with you -- an account to which all client payments are made and all factor payments are disbursed.
The factoring company will likely file a blanket Uniform Commercial Code (UCC) to secure the factor’s first position security interest on the invoices funded. The filing is a lien collateralizing your receivables. Typically, a factor will file a lien on all your receivables, even though you may only be factoring a portion of your sales, as a way to notify other lenders researching your company that an agreement exists between your company and the factoring company.
Controlling Risk -- recourse and nonrecourse.
As we mentioned earlier, recourse factoring protects the factor. If a client doesn't pay an invoice after a specified period of time, the factor with a recourse arrangement will demand that you repurchase the invoice at face value.
Many factors will offer nonrecourse agreements, in which they assume all risk, but at a higher discount rate. Most recourse factoring is done by smaller factoring firms.
Most factors will require you to send all of your receivables through their system, as mentioned earlier this helps to offset risk. Selling one invoice at a time is called spot factoring and it's generally available, and naturally it’s more expensive. There is increased fraud risk with spot factoring, so the diligence and notification requirements are more stringent.
Factoring: The cost
Like most financial products, factoring costs will vary from client to client and are dependent on many different criteria.
“Factor rates vary from one to seven percent, depending on a lot of different variables,” said Bert Goldberg, executive director of the International Factoring Association. Some of those variables include:
· Credit worthiness of the debtors
· Volume and value of the invoices of the account,
· Industry
· Time involved
The primary fee to which you should pay close attention is the Discount Rate which is typically 1% to 5% per month. A 1% fee is likely to be offered only to rock-solid clients factoring millions of dollars in receivables every month. A 5% fee or more reflects the most extreme risk that's still tolerable -- a relatively small amount to factor, from less credit-worthy customers, and a less credit-worthy client in a risky industry. Factors generally apply this discount rate in 30-day blocks, even if payment comes sooner.
The more of your receivables you factor, the lower the discount rate because the factor will be able to offset the risk of some of your slower receivables with those of your higher-quality customers.
Best practices and guidelines:
· Expect to negotiate terms on receivables carrying little to no risk, compared to receivables with long shelf lives.
· Older invoices will generally draw a higher discount rate.
· Some factors will offer a discount for early payment from customers with outstanding bills.
· Some factors will allow you to negotiate the discount rate to be applied in periods of 10 or 15 days for larger or more reliable accounts, potentially saving you percentage points on a sale. Start looking for 10-day discount rates when your invoices top $250,000 a month.
Here are some additional guidelines, courtesy of Barret Ayres, a factoring broker and principal of NPK Funding.
The factor will generally pay about 80 percent of the face value of an invoice, reserving the rest (less the factor's fee) until receiving payment from your customer. That reserve rate varies, depending on industry. Medical factoring companies generally hold back more, because of the volatile nature of medical billing claims.
Invoices worth $50,000 each month may be expected to carry a discount rate around 3 percent per month, Ayres said. As the amount to factor rises, discount rates fall. A factor offered $250,000 each month in receivables could offer a lower discount rate after negotiation, to 2.5 percent each month. At $1 million a month in receivables or more, 2 percent monthly factoring rates are not unrealistic, Ayers said.
The relationship:
When you arrange to work with a factor, you will routinely share and discuss every meaningful financial aspect of your business. The factor becomes a kind of auxiliary finance officer. Once you become a client, the factor has a deep interest in the success of your organization.
Since the factor will have interaction with your clients, pay attention to the reputation of the factor – one bad experience with an aggressive factor trying to collect on a debt can sour your clients on repeat business with you.
Interviews with factoring clients lead us to conclude that clients and factors both prize honest and open communication. A typical relationship with a factor lasts from 18 to 24 months. In many ways, factoring is a stepping stone for a growing company, one too big to finance their operation on credit cards, but too small to qualify for bank financing.
Some factoring agreements require customers to factor a set amount in receivables each month, for a period of months. Ending this kind of agreement early can require a penalty payment, depending on your contract terms.
A factoring story
Jim LaBarber intones the small business person’s mantra of the age. "It’s the same old story…if you don't need the money, the bank is more than happy to loan it to you," he said.
LaBarber, president of Anaheim, Calif.-based flooring company UNIKA USA, Inc., uses two factors to finance his manufacturing business. One manages his accounts receivable. Another manages elements of his purchase orders for offshore operations. UNIKA USA makes floating vinyl flooring in China and a floating tile installation system in Canada. He sells more than a million dollars of invoices every year to his factoring partners.
LaBarber views it as a necessary means to an end -- a consequence of growth. "Trying to apply for an SBA loan from a major bank when you haven't been in business for at least two years I’ve found to be impossible as they won't even talk to you," Labarber said. "Consequently, you then try to find a factor that will talk and work with you, that comparatively has the best rates."
UNIKA USA began operations at almost the worst possible moment for a startup seeking financing -- the fall of 2008, just as the financial world was collapsing along with the housing market. Nonetheless, his company has been growing, despite the weakness in the broader market. But to work with his supplier in China, LaBarber needed letters of credit, which required financing in place. He worked with factors earlier in his career while running other firms, so he had some sense of the path forward.
"You initially look for the company with the best terms," he said. His first shot at a factor turned out poorly, though. "You have to proceed with caution," LaBarber said. "The receivables company that we had originally selected required a $3,000 dollar deposit just to process the paperwork. At the 11th hour, this company wanted a $35,000 premium to buy insurance." Shocked, LaBarber demanded his initial deposit back and found another factor within 24 hours with the help of an industry professional he’d been working with.
"You have to be very, very careful when going through these documents filled with mystical legalese. Consult with your attorney for clarification and reassurance."
He and his receivable factor had a short dust-up over missing an estimate for revenue at one point. UNIKA USA was factoring fewer invoices than expected. His factor argued that the shortfall in invoices harmed them financially. The two settled their differences, but only after some intense negotiations. A clear understanding of the contract is essential as well as its interpretation. "In the end, the relationship that you develop and the clarity that you provide typically prevails with reasonable people.”
A few tips: LaBarber noted that an order has to be minimally profitable for his factor to even consider it. "Let's say the product costs 70 cents to manufacture. The factor I'm dealing requires at least a 30 percent profit to do the financing." As a relatively new corporation, LaBarber's factor required him to personally guarantee the notes he sold. “At 3 percent a month from my P.O. factor and 2 percent from my receivables factor, factoring costs UNIKA USA a total of approximately10 percent in margin per order,” he said.
"If you don't have adequate financing, factor. If you do, don't factor as the combined costs can be prohibitive." LaBarber said. Factoring makes financial sense, when approached with the right attitude and with your eyes open. "Do your homework. Don't just settle for the first guy that's willing to do business with you. People still do business with people. Find the right people and there’s a good chance that the company will provide the best short term growth opportunity for you."
Definitions
Advance Rate: Money a factor pays up front when purchasing an account receivable invoice. Usually, a factor pays between 70 and 90 percent of an invoice's face value, depending on the industry and the risk of collection.
Asset-based lending: A loan, not a purchase. A lender looks at the value of a borrower’s assets -- inventory, equipment, property and accounts receivable -- and lends using that property as collateral.
Cash conversion cycle: The period of time between spending money to start a business function, and the time that business function returns cash to your account.
Commercial debt: What your client owes you for goods delivered or services rendered. Usually, it's due for repayment in 30 to 90 days.
Concentration: The percentage of accounts receivable due from a single customer.
Creditor: The party to whom money is owed -- in this case, both you and the factor.
Debtor: The party that owes money on an invoice purchased by the factor.
Discount Rate: The factor's fee -- typically 1 to 5 percent per month.
Factoring: Selling the right to collect on a debt to a third party. The debt, an account receivable, is priced at less than face value. Typically, debt is bought at 90 to 97 percent of its face value, with from 70 to 90 percent paid up front and the rest when the debt is collected.
Factoring Broker: Someone who specializes in matching factors with customers.
Reserve: How much money retained by the factor until the factor collects from the client’s customer. The client receives this money, less the discount rate, once payment is received by the factor.
Schedule of Accounts: A factoring client’s information about the account of each of the client's customers.
Verification: Part of the notification and due diligence process for a factor. The factor must verify that the invoice it bought comes from a legitimate transaction, and that the client’s customer knows it owes money to the factor.
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