In factoring, a factor is a specialized financial institution that buys the receivables of its customers at a discount and then collects those receivables directly. Factors typically specialize in one or more types of businesses so they can efficiently gather and use credit information about those industries.
KEY POINT: Selling its receivables to a factor provides the small business with immediate cash, reducing its need for financing. The factor also may take on the credit risk associated with the receivables if the receivables are purchased on a non-recourse basis.
Recourse agreement vs Non-recourse agreement in factoring:
In a recourse agreement, the factor’s customer agrees to repurchase or pay for any receivables the factor purchased and cannot collect. With a non-recourse agreement, the factor purchases the receivable outright from the company and owns it regardless of whether it can be collected. Because a non-recourse agreement presents greater risk to the factor, these agreements contain provisions allowing the factor to refuse to purchase receivables at its discretion. They also give the factor the option to purchase any of the business’s receivables, protecting the factor from being offered only the most doubtful ones.
Non-recourse factoring costs more than recourse agreements. Factoring has many advantages for a small business, particularly one that is short of cash:
Advantages of Factoring:
1. Factoring can accelerate the cash flow into a company from its sales.
2. Factoring can be utilized whatever the credit quality of the company using factoring because the factor looks to the credit quality of the company’s customers who generate the receivables and not to the credit quality of the company itself.
3. The company avoids having to take on debt on its balance sheet, although the low level of accounts receivable will suggest that factoring is being used.
4. A factoring arrangement can reduce the staff of the company by shifting the administration of receivables to the factor.
WATCH THIS: Despite its advantages, factoring can be expensive. Some customers may find the factor’s credit checks intrusive. In some industries, use of a factor is considered a sign of financial weakness.
Cost of Factoring
The benefit of factoring can be judged from the cost involved in collecting the payment from the buyer. A seller can adopt two methods for collecting sale proceeds —
- Maintaining his own collection department.
- Collecting the sale proceeds through factor.
Maintaining his own collection department
While maintaining his own collection department, a seller has to incur the following expenses—
- cash discount
- making bills for account receivables
- bad debts
- lost contribution on past sales
- sales ledger administration
- monitoring of credit.
Collecting the proceeds through factor
- factoring commission
- discounts allowed
- cost of funds blocked up in the long term credit.
The benefits through factoring not only minimizes the bad debts but also maximizes the revenue.
You can learn more about factoring or find a factoring company through the Commercial Finance Association at www.cfa.com