The Creative Alternative Financing Mechanism
The word “factor” comes from the Latin “factare” meaning “to make or to do”. This financing mechanism dates back to the time of Hammurabi. it has been part of the basic fabric of all trade.
The concept of “making it happen now” continues. Essentially it is the sale or assignment of a sale, trade, or accounts receivable account for immediate cash. By definition, it provides any business from start-up to mature companies (at any size), access to immediate cash and improved cash flow for expansion or growth but without diluting equity or incurring debt.
The reasons for using this financial tool are just as numerous as they are varied:
- take advantage of trade discounts or other early payment options with suppliers or vendors and
- ability to re-invest immediately to acquire new sales opportunities;
Since the factoring firm effectively assumes the credit evaluation risk of accounts receivable that may translate into decreased internal costs for accounts receivable administration, more efficient and effective customer accounts collection (quicker pay), and better information for management on the credit worthiness of the firm’s clients;
- increased working capital turnover as well as a reliable source of immediate financing; and
- other financing options may not be available or timely for firm requirement(s).
The essence of the transaction is the credit worthiness of the particular receivable account, so long as the firm has marketing strength and aggressive sales efforts. Regardless of stage of development (even in bankruptcy), immediate cash may be available.
Factoring is not a collection system for bad debts or even slow pay accounts. Use of factoring may however tend to speed the payment from an otherwise slow-pay client once the disciplined payment techniques of a qualified factor are introduced. As with any “financial tool”, there may be wide variations in applicable terms, conditions, and cost rates for its utilization.
For example, advance rates (percentage of invoice paid in advance of collection) may vary due to account risk, industry, and factoring firm. The discount rate (fee charged by the factor for the financing) may also vary by actual risk in the account, industry, and/or factor firm. Transactions may either be “recourse or non-recourse” (return liability or guarantee of collection from the firm) which may take the form of merely replacing a receivable if it reaches a previously agreed upon age.
All of these variables then come together in a “risk evaluation” cost rate or fee for the factoring service. As with any type of financing, the greater the perceived risk, the greater the cost for the service. The range for the first 30 days might be expected to be 2%-7% of the gross value of the account financed, with 5% being typical.
There may also be a wide variety of other terms and conditions in the transaction such as:
- Minimum invoice amounts (i.e., $200 – $500), minimum monthly volumes (i.e., $10,000 – $500,000), and/or time period commitments (i.e., 6-12 months).
- Notification and non-notification to the receivable account that a factoring transaction has occurred.
Just like all financing options, the business firm must evaluate its own individual needs and requirements including a focused evaluation of all actual or potential advantages versus the costs in the transaction. In most circumstances and at every stage of development, factoring, if properly utilized, can be a very valuable financial tool to achieve expanded sales and company growth.
Not all factoring companies are alike, often with wide variations in terms, conditions, and rates depending on your firm’s needs and accounts receivable (as well as size and geographic coverages -local, regional, and national).
Wayne Caskey, Executive Vice President, Reservoir Capital Corporation, Baltimore, MD
