Magazine article Business Credit

For Small Firms, Credit and Collections Can Now Be Done the Old-Fashioned Way - by Factoring

Magazine article Business Credit

For Small Firms, Credit and Collections Can Now Be Done the Old-Fashioned Way - by Factoring

Article excerpt

Factoring: the purchase of a firm's accounts receivable by another firm (the factor) for a discount fee, thereby relieving the seller of the trade credit risk and some of the collection work.

Long since a staple of the garment industry in New York, the Carolinas, and Los Angeles, factoring is now widely available to commercial firms of just about any size in just about any industry. This new breed of factor differs greatly from the traditional counterpart. It is these differences that must be understood by today's credit managers if factoring is going to find a home within the small business community, the way it has with the apparel, textile, carpet and furniture industries. To appreciate how the small-business factors differ from the traditional factors, we must first examine the tradition.

The History of Factoring

The word "factor" means "to facilitate" and has its roots in Greek. What factors facilitate is trade, and they do this by removing the risk of open trade credit. While factoring has been around for hundreds of years (Martin Luther's father ran a factoring operation), it found its way to America during the time this country was being settled. When trade began between England and the New World, open credit took on a whole new meaning as shipments going from one side of the Atlantic to the other would have a collection cycle of many months, with the increased risks of pirating, ships sinking, and of course, collecting from an entity thousands of miles (and an entire ocean) away. At this time, factors stepped up and guaranteed merchants that, if they shipped to certain pre-approved entities, the factor would make good on the debt should payment not be made within a specified time. Absent these factors, "free trade" would have been sharply curtailed.

Today's traditional factors have been around for an average of 50 years and most are part of larger, financial conglomerates. Their main purpose is to provide credit and collection services for a fee. Operationally, the factor pre-approves and sets credit limits for all its client's customers. The clients will send the factor their sales (invoices) as they are generated, notify the customer that the factor is now handling collection (so that the remittance address is changed) and will pay a set percentage of these sales (.25 percent to 1.5 percent on average) to the factor. In return, the factor guarantees collection. If no payment is received in 120-180 days, the factor pays the client. For maturity factoring, the factor pays on the invoice due date. This form is more expensive, but it gives the client a sure and steady cash flow. Also, clients can often obtain lines of credit tied to their accounts receivable from an affiliate lender of the factor because, from the lender's point of view, the collateral is literally being managed in house.

Why pay a factor when credit insurance does much of the same thing? First, traditional factors specialize in the aforementioned industries and concentrate on sales to retailers (although, sales to wholesalers have become an increasing percentage of their volume). This long history of primarily rating retailers of textile goods has endowed these traditional factors with proprietary credit information unparalleled by even the largest credit reporting agencies or credit insurers. Simply put, to this market, they provide superior credit information. The second primary benefit provided by these factors is their relative collection power. Well over half of the textile vendors that supply to retail use factors, and most of this activity is concentrated in just a handful of factors. Therefore, when one of these factors is owed money by a company, the trade debt represents hundreds of vendors. So, although losing a single vendor because of late payments might not bother a large company, losing hundreds of vendors all at once would be quite a different story. Simply put, factors get paid on time!

In order for a company to qualify as a traditional factoring client, it must have a track record (1-2 years in business) and meet some minimum sales requirement ($1-2 million annually). …

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