Require Financing ASAP? Contemplate Factoring Receivables

Factoring receivables refers to a transaction where a commercial business sells its accounts receivables (debtors) to a factoring firm at a price discounted from their book value and to be settled immediately. The main benefit of accounts receivable factoring for the business is that it gets paid the cash price immediately, improving cash flow. Second, it does not carry the risk of debtor default. Of course, the cost the business pays for these benefits is that it is paid only a factor, or fraction, of its debtor book value.

For example, a commercial firm has an accounts receivable balance of $10,000 with an average credit period of 30 days. That commercial firm may be offered $9,000 for those receivables by a factoring firm, representing a factor of 0.9 or 90 percent. If this offer is accepted, the receivables are then owned by the factoring firm and it has the task of collecting the $10,000 amount from each of the individual debtors.

In the above example, the $1,000 gap between the book value and price paid for the receivables represents the discount required to be offered by the commercial firm in order to attract the factoring firm as a buyer. The size of the discount mainly reflects the risk of default by debtors, the time cost of money and a profit margin for the factoring firm. Each of these three points can be considered in more detail.

Having purchased the debtors means that defaults by debtors is borne by the factor firm. If it experiences a 8% non-payment rate it collects only $9,200, not $10,000, from debtors over the average 30 day credit period. Allowing for this $1,800 default cost, the gross profit enjoyed by the factor firm is $200 divided by $9,000 equals 2.2 percent monthly (30.2 percent yearly compound).

The time value of money is an opportunity cost for the factor firm since it foregoes the opportunity of earning a risk-free return on the $9,000 it used to acquire the debtors. By using those funds to invest in debtors, the factor firm cannot invest that $9,000 in the risk-free money market deposit. If the interest rate paid on that money market deposit is 0.5 percent each month (or 6.2 percent each year), the factor firm loses a worry-free monthly interest return totaling $45.

The factor firm has, in effect, swapped a risk-free $45 profit for a risky outcome that may even be a loss. As it happens, in the above example, this risky outcome turns out to be a $200 profit. By not accepting a risk-free $45 the factoring firm earns an incremental $200 – $45 = $155 profit. This incremental profit represents the reward for carrying the risk of default by debtors. It translates to $155 / $9,000 = 1.72 percent monthly or 22.7 percent yearly.

To generate this incremental 22.7 percent yearly return, the factor firm has to carry the risk (accept the possibility) of an infinite outcomes, including possible losses. For example, if the debtor default rate had of been, say, 12 percent rather than 8 percent, then the factoring firm would collect only $8,800 during the credit period and suffer a loss of $200 instead of a worry-free profit of $45.

Any business attempting asset based lending will be required by the factor firm to submit detailed information about itself and its customers or debtors. The factoring firm is concerned to arrive at a detailed assessment of the overall credit risk of immediate debtors and the overall customers of the business. If at all possible, the firm would like to arrive at a credit assessment of the customers independent of their past credit performance with the business.