Sadie Keljikian and David Estrakh, Express Trade Capital
Factoring receivables is a simple, elegant solution for insufficient cash flow in business-to-business sales relationships. It allows vendors to sell large orders to retailers and assign the receivables to a third party, thus avoiding depleted operational funds while outsourcing collections labor and risk. Factoring often refers to a variety of different services bundled together: (a) A/R management and collections; (b) credit protection; and, most popularly (c) cash advances against receivables.
If you’ve recently decided to factor your receivables, you probably find yourself dazzled by the varieties of factoring and at a loss to distinguish how they differ from one another. Each type of factoring is ideal for addressing specific circumstances depending on the industry, sales volume and customers involved, among other criteria in addition to the specific needs and wants of the factoring client.
The following are a variety of factoring methods, some of which can be combined or modified to suit the client’s needs:
A very common practice for factoring receivables in general, a full-recourse factoring arrangement transfers the debt on invoices to the factor in question, but leaves the credit risk with the client. In other words, the client agrees to buy back invoices if the factor is unable to collect payment. This arrangement is popular when the client’s customers have poor credit and/or a history of delinquency on payments, because it does not require that the customer have good credit. While it is generally costlier because the risk is higher, full recourse factoring is also a good solution for clients who do not want their customers contacted. Many recourse factors are more willing to allow payments to be made to a lockbox in the client’s name rather than directly to the factor as is the case with non-recourse factoring.
Contrary to full-recourse factoring, non-recourse factoring means that the factor absorbs the credit risk on factored invoices. This means that the client is not responsible for customers who pay late or not at all due to issues like bankruptcy, insolvency, and even refusal to pay without reason. In addition to lower costs, outsourcing collections, and enhanced lending options, non-recourse factoring has the added value of protecting the factoring client from poor credit or lost capital at the hands of delinquent customers. However, to secure their receivables collateral, non-recourse factors want to notify and collect directly from the factoring client’s customers, which some factoring clients prefer to avoid.
An advance factoring agreement is one in which the factor advances the client a substantial portion of their receivables as soon as the goods are sold to the customer, less any fees. The customer then pays the factor within the terms of the invoice. Advance factoring can be done with or without recourse and is one of the more common varieties of invoice factoring. Advance factoring can also be called “receivables financing.” Since all open invoices are by definition considered receivables, any funding provided by using the receivables as collateral or security for the funding is considered receivables financing. Most factors offer advance factoring and most clients are mainly interested in this component of factoring, which is separate from the collections, credit protection and A/R management services.
Spot factoring allows the client to choose individual invoices to factor, rather than all open invoices or all of the invoices with a particular customer. This allows a vendor to fulfill small numbers of large orders as they come in, without worrying about insufficient operational costs or relinquishing control over the rest of their accounts receivable. The advantage is that the factoring client has very minimal or no commitments to assign invoices. However, since the factor is taking on a larger risk and smaller volume, their rates are often substantially higher than traditional factoring rates which are given with the understanding the factoring client will factor all, or most, of their receivables.
This is a good option for clients looking for something in between the traditional factoring requirement to assign all receivables and the spot factoring option of no commitments but substantially higher costs. For those who don’t have enough sales volume to enter a long-term contract with a factor, selective factoring is a very helpful solution. Rather than factoring all or most receivables, which is very often required in traditional factoring agreements, specific accounts are chosen and only those customers’ invoices are factored. This means that a vendor with several small-scale retailer customers and a few big-box stores can accommodate the needs of both by factoring the large customers and handling the small accounts on their own (or vice versa at the client’s discretion).
In bulk factoring agreements, financing is provided for the current total value of the client’s accounts receivable, rather than the usual practice of factoring invoices. There are a couple of reasons why a client might want to take this approach. Bulk factoring is popular among large-scale distributors who need to clear their balance sheets and improve their liquidity. It can also be helpful for vendors whose sales are mostly quite small and distributed among many customers, since bulk factoring removes the need to factor specific invoices. This practice also appeals to a lot of businesses because the client typically remains in full control of accounts receivable operations, including collections, keeping operational responsibilities in-house.
If you prefer for your factor not to contact your customers, non-notification factoring is for you. This arrangement can be a bit more expensive, as the factor will have to do more work to avoid contacting customers. Funds often go to a lockbox and the factoring client’s customer may be unaware that the invoice is factored at all. While this is a good system for customers who might be slow to trust, you’ll find that many retailers are familiar with factoring and aren’t concerned by their invoices being factored. Non-notification factoring is usually coupled with recourse arrangements because non-recourse factors who offer credit protection on receivables want more control, which requires handling invoices directly and notifying the customer. If you want credit protection, this may not be the best option – it’s costlier and riskier, and its only advantage is that your customers are not notified by the factor.
In maturity factoring agreements, the factor takes over all credit, collection, and accounts receivable management functions and usually provides credit protection on the client’s receivables. Funding, however, is not provided to the client until the due date on the invoice or slightly thereafter. Basically, the factor performs all the service functions of factoring without the lending component and thus, there is no interest charge in the arrangement.
Industry Specific Factoring
Standard factoring usually applies to wholesalers who sell consumer goods to retailers. However, there are many industries that are unique enough to warrant factors that just cater to them. Some of these industries include healthcare, commodities, construction, shipping/logistics, service providers, and US exporters selling mostly to foreign countries, among others. Each industry has its own risks that require specialized knowledge. For example, to provide factoring on medical receivables, a factor must be familiar with how medical billing works and how insurance companies treat certain invoices, while factors who service sellers of certain food products should understand USDA and FDA regulations.
Although some factors have multiple specialties it is best find a factor that knows and specializes in your particular industry. Since factors are, by the nature of the relationship, watching out for their clients’ best interests and making sure they get paid, a good relationship usually involves some informal guidance and consulting. Consequently, it is enormously helpful if the factor providing the guidance has firsthand experience with and knowledge of your industry and the corresponding mechanics of it.
Each of the above varieties is designed to serve specific financial and organizational priorities, but the overriding theme is that most factoring is geared to keeping your cash flow healthy and your receivables safe.
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