Factoring Might Not Be Right for You, But It Could Be Just What Your Customer Needs to Pay You on Time (from the May 1999 edition of Credit Today)

Although factoring transactions go back to the times of the Pilgrims on this side of the Atlantic and even to ancient Rome on the other, its major impact in the U.S. occurred in the Garment District in New York City. Almost all business-to-business transactions in the Garment District still involve factoring in some fashion.

Typical Client

The typical factoring client often does one thing very well–provide an excellent product or service. Sales are strong, growth is rapid, and its customers are clamoring for help. The problem is that growth that may be too rapid: inventories cannot meet demand; service orders go unfilled; A/P is strung out because cash flow is poor; and taxes get backed up. Too much time is spent on crisis resolution and not enough on effectively managing the growth.

The first step is often to turn to the bank. AAA Bricks goes to Home Towne Bank to ask for a credit line. AAA has had an operating account with Home Towne Bank for the whole 14 months of AAA’s existence. Since its business has grown, AAA thinks that Home Towne will be able to give them a line to meet expenses and help the company grow. Home Towne Bank’s credit committee reviews the account, runs the numbers through the bank’s credit scoring model, and rejects the line. It determines that AAA has an insufficient history, and it views the cash flow problems as a negative.

AAA then gets a tip from a colleague about Factor USA. Why would a factor be willing to help when the bank just turned down a loan? Because the bank and the factor are looking at the same facts, but each from a different perspective. While the bank looks at AAA’s financial strength, the factor looks at the strength of AAA’s customers (known as debtors in the factoring community). It sees AAA Bricks’ growth as a positive and looks to partner with AAA to fund that growth. Longevity, financials, and the principal’s history are considered to be secondary to debtor strength and the ability to get a security interest on the receivables.

Benefits

Financing through a factor instantly speeds up cash flow. Cash can be used to catch up with past due A/P, meet payroll, buy equipment, increase inventory, meet vendors’ prompt-pay discounts, fund new projects, and pay taxes.

Procedures

Factor USA will review AAA Bricks’ debtors using traditional credit management methods and do an overview audit of AAA’s policies, procedures, financials, and principals. If approved, AAA will send all invoices to Factor USA for factoring. Factor USA will run the invoices through a verification process, which generally involves contacting a random sampling of account debtors to insure invoices are correct and proper for payment (and have not previously been paid).

Once approved, Factors USA will wire AAA Bricks an advance on these receivables, which can generally be 70 to 80 percent of invoice face. Factors USA will take a security interest in all A/R and any other assets as agreed. All debtors are notified of this financing agreement and instructed to send future payments to Factors USA. As invoices are paid, Factors USA will deduct the advance amount and any fees accrued and send the balance back to AAA Bricks.

Factoring & the Credit Manager

Credit managers often have clients that are strung out on payments with no apparent hope of recovery. Prior to write off or submission to a collection agency, the credit manager might wish to consider referring the customer to a factor. Many companies aren’t aware of the benefits of factoring, and it just might be the best alternative for all involved. In return for your help, the customer might be able to pay off your invoices out of the first funding. Instead of no or partial recovery, you get full recovery.

It’s Not For Everyone

Factoring isn’t for every company. Some are viable enough for traditional bank financing. Some are in major financial difficulty, and bankruptcy may be the only answer. Keep in mind that factoring isn’t cheap; it often can be 1.5 to 2.5 percent of the amount of your receivables per month. Margins must be sufficient to cover these rates, or a short-term solution could turn into a long-term problem. But in the right situation, factoring can provide enough working capital to pay off the vendors and to grow the business.

Robert Holt is President, Baltimore Credit & Collection Services, Inc.,
410-549-6444; www.bccs2.com