Magazine article Business Credit

What Creditors Should Know about Factoring

Magazine article Business Credit

What Creditors Should Know about Factoring

Article excerpt

Factoring is a short-term financing technique used by a variety of businesses in which the accounts receivable of a company are discounted to a factoring institution in return for cash. A factoring institution may be a factoring company, commercial finance company, or a full-service bank.

The factor may purchase receivables "with recourse" or "without recourse." Recourse means the factor has recourse to charge bad debt losses back to the client. A non-recourse arrangement means the factor accepts all risk and absorbs all credit losses. A popular arrangement involves the client and the factor sharing the risk in the form of a deductible on bad debt losses. The factor provides these services in return for a fee and interest on money advanced against invoices.

Factors, Factors, Factors

The factor sets the fee and reserves after conducting an analysis of the client's receivables and customer base, evaluating items such as:

* The number of active customers and their credit-worthiness;

* The average invoice dollar amount;

* The size of the average account; and

* The age of the average invoice.

Factors handle much of the credit function for their clients--including checking credit references, approving open accounts, recommending credit limits, handling A/R and cash application, and collecting past-due balances.

The factored client normally chooses to receive payment at the time invoices are presented to the factor. A reserve is deducted for discounts and discrepancies. The client then pays interest for either the actual or average number of days the money remains outstanding.

Pros and Cons Explored

Some of the seller's advantages in factoring receivables are:

* In the short-term, factoring may be less expensive than hiring a credit manager and establishing a credit department.

* It is one of the fastest ways for small businesses to raise cash. It may be the only option available to some companies that are unable to get money from other sources of short-term financing.

* Factoring is an alternative to purchasing credit insurance.

* It permits rapid turnover of accounts receivable, which may be especially helpful to fast-growing companies.

* If the company selling its A/R is willing to assume or share the risk of bad debt losses, the factor will provide its services at a lower rate than if it were purchasing the receivables without recourse.

* The cost of having and running a credit department is reduced (but not eliminated) in a factoring arrangement. …

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