WHAT IS FACTORING?
Factoring is a financial strategy that allows businesses to obtain money from their receivables before customers actually remit payments. Factoring –also referred to as a / r financing- is a form of asset based lending that is used by a wide array of companies in various industries. Factoring is used by companies varying in size from a single employee to Fortune 500 companies.
In short, factoring allows businesses to sell their a / r to a factoring company in an effort to increase their cash flow. Accounts purchased by factoring companies typically collect in about 45 days. A lot of factoring companies restrict accounts eligible for purchase that are aged Sixty days or less. However government receivables are typically accepted at 120 days.
Factoring is sometimes wrongly perceived as bad or final option financing, needed by financially troubled businesses that cannot obtain bank financing. In reality, nearly all American factoring volume arises from contracts between large successful businesses, many of which are creditworthy, however they utilize factoring for its many benefits we discuss below.
Beyond the traditional factoring markets such as staffing, textiles, transportation, and medical, factoring companies these days purchase accounts from clients in nearly every industry, including electronics along with other consumer goods, government contracts, medical services, construction, and other service industries.
In spite of the prevalence of factoring in the US, small business owners, attorneys, accounting firms, financial professionals and judges have little understanding of this old type of commercial finance. Below is information that will help define factoring.
Additional SERVICES PROVIDED BY FACTORS
Factors provide a number of services to their clients related to the factoring transaction. These include:
In non-recourse (and partial non-recourse) factoring, factors provide credit protection to their clients. If a credit-approved account that a factor purchases without recourse is not disputed by the account debtor or otherwise ineligible, and is not collected due solely to the financial inability of the account debtor to pay, the factor must pay the full purchase price to its client.
Bookkeeping and collection services.
Factors often provide bookkeeping (ledgering) and collection services to their clients for the purchased accounts. However, in certain non-notification factoring transactions, the factor hires its client to service the purchased accounts, as agent of (and under control of) the factor (see below Notification and Verification).
Factors often provide financing to their clients by making an advance on the date of purchase. Typically, factors will advance an amount between 70% and 90% of the purchase price of the subject accounts. The advance can either be treated as an interest-bearing loan or as a partial prepayment of the purchase price. Most large factors treat advances as loans.
ADDITIONAL SERVICES OFFERED BY FACTORS
Beyond factoring facilities, many factors also offer a range of other services to their clients, such as: Accounts receivable financing (revolving loans), inventory loans and other forms of asset-based lending, such as term loans.
Purchase order financing.
Letters of credit.
Government contract financing.
Import-export financing and other forms of trade finance.
ADVANTAGES OF FACTORING
Businesses can garner several benefits by factoring accounts, as compared to traditional bank financing. These include: Reduction of credit losses, in non-recourse and partial non-recourse factoring, by the factor’s assumption of the credit risk on approved accounts.
-Reduction of credit and collection expense, and increasedefficiencies in the billing and collection functions, by outsourcing some or all of these functions to the factor. This allows the client’s management to focus their attention on production, marketing, purchasing and other functions, which can beespecially attractive to small and mid-size businesses.
-Improved and more timely financial reporting, from the factor to the client, on matters such as: zzthe aging of open accounts;
- account debtor payment (collection) history;
- credit risk;
- disputes with account debtors; and
- deductions claimed by account debtors on their accounts, such as deductions taken for lost, returned or damaged goods or discounts claimed by the account debtor.
-Ability to obtain financing in the form of advances by the factor against purchased accounts, in advance factoring facilities. Alternative forms of financing, such as asset-based lending, might not be available to a business, particularly if the factoring client:
- is newly formed;
- is growing rapidly;
- is thinly capitalized;
- has a narrow customer base, so that a large volume of accounts are payable from only a small number of customers (excessive concentrations);
- has slow-paying customers (bad turnover);
- has high credit losses; or
- is financially troubled
-Few or no financial covenants, with higher or even unlimited funding on accounts accepted for purchase, especially in non-recourse factoring facilities.
-More limited guarantees. For example, the factor may accept a validity and non-diversion guarantee from the client’s principals that does not extend to credit risk assumed by the factor. By contrast, a lender might require a full guarantee.
-Enhanced ability to raise sales and smooth out seasonal fluctuations in demand, for example, by obtaining seasonal over-advances from the factor. Here, the factor will make an advance to the client, in anticipation of later arising accounts receivable (not presently existing) to be generated by the client and sold to the factor at a later date.
-A closer working relationship with the factor’s employees than might exist with a bank loan officer administering a line of credit, together with access by the client to the factor’s specialized industry knowledge.
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