Simply put, factoring is a transaction where a company sells its invoices at a discount in exchange for quick funds.

Transcription

1 Imagine your growing business just made a six-figure sale to a company across the country. The problem? The buyer has 60 days to pay, but your cash flow is limited, meaning you can t afford the immediate fuel and payroll costs to ship the goods until they make payment. You ve tried talking to the bank about pledging your receivables to obtain a loan or line of credit, but you lack necessary capital. Plus, you d rather not take on more debt anyway. Enter accounts receivable factoring. A factoring company will pay you up to 95 percent of the invoice value in as little as 24 hours. Once your customer has paid the invoice, the factor remits the difference back to you minus a small fee. This influx of cash allows you to make the shipment with room to operate and pay expenses comfortably. How Factoring Works Simply put, factoring is a transaction where a company sells its invoices at a discount in exchange for quick funds. The term factoring refers to the outright sale of accounts receivable to a financial services company known as a factor. The factor pays the seller, or client, a percentage of the face value of the invoice. This payment is called an advance and it happens almost immediately. The party responsible for actually paying the invoice is referred to as the customer. Once the customer has paid the invoice, the factor releases the invoice balance (known as a reserve ) to the client minus the factor s earned fees usually less than five percent of the total. The specific process by which a client submits invoices, receives advances, and collects the reserve varies. Still, in most cases, the factoring process will encompass the following steps: 1. Client sells goods/services to customer The client decides which invoices or which parts of invoices to factor. There is no limit on invoice volume. However, factors evaluate the creditworthiness of customers and may exclude certain high risk or foreign accounts. 2. Client sends invoices to factor Invoices reach the factor in one of two ways: Client sends invoices directly to the customer accompanied by factor s contact information and remittance instructions. The factor receives an invoice copy. Client sends invoices (often in batches) to the factor. The factor then bills customers on behalf of the client. The factor then verifies invoices by telephone, purchase order, or random spot check. 3. Factor pays client advance Once invoices have been verified on pre-approved debtors, a factor pays the client an advance. Factors pay anywhere from 70 to 90 percent of the invoice value up front, though advances can be as low as 50 percent and as high as 95 percent depending on several factors such as customer credit, payment history, and size of the receivable.

2 4. Factor tracks invoices and collects payment Even if a client bills customers directly, the factor still owns the invoice and handles collections. 5. Factor disburses reserve After deducting fees, the factor disburses the reserve balance to the client. Disbursement may happen at several intervals: Factor pays reserve for individual invoices. This is less common, but in some cases factors send reserves in batches once a week. Factor pays reserve only after a sufficient batch of invoices has been paid in order to recover the majority of the advance. Factor pays reserve only after all invoices have been paid in full. As for fees, factors charge around 1.5 to 5.5 percent of the total invoice amount. Be aware that some factors establish an initial fee that gradually increases over the length of the collection period. 6. Factor reports to client A factor reports to the client periodically throughout the factoring relationship. Factoring reports may include information on Payments collected; Generation of rebates; Aging report on outstanding invoices; Accrued fees; Customer disputes, etc. What happens if customers don t pay? If a customer fails to pay an invoice, a client has several options depending on whether the factor operates on a recourse or non-recourse basis. Non-Recourse Factoring lower risk, more expensive In non-recourse factoring, the factor is responsible for the cost of unpaid invoices. By buying the invoice, the factor has also purchased the risk associated with non-payment. Recourse Factoring- higher risk, less expensive In recourse factoring, the client is responsible for the cost of unpaid invoices. The factoring agreement may require the client to repurchase any invoices that are unpaid after a certain period (usually 90 days). NOTE: Non-recourse factoring agreements differ across providers. Some factors will only assume responsibility for unpaid invoices if the customer becomes insolvent within a 90-day period. Other factors agree to absorb the loss of unpaid invoices, regardless of whether the customer is insolvent. Still others give the option to swap the outstanding invoice for a new one. Always review the non-recourse agreement carefully to see what your obligations are should a customer decide not to pay.

3 Accounting for Non-Recourse Factoring Pegasus Organic Foods sells 1,000 granola bricks to GreenMarket for $10,000 on net 30 terms. But the granola bricks are a hot item, and Pegasus has already received purchase orders from four neighboring supermarkets. Without factoring, Pegasus would have to delay subsequent orders until it receives GreenMarket s payment because of the steep cost of organic ingredients. Pegasus turns to non-recourse factoring. A factor agrees to advance Pegasus 80% of the invoice ($10,000 * 80% = $8,000) with a 7% fee ($10,000 * 7% = $700). GreenMarket pays within 30 days, so factor remits the balance minus fees ($2,000 - $700 = $1,300). Pegasus ultimately recoups $9,300 of its $10,000 receivable. $8,000 immediately and $1,300 after 30 days. Without Recourse Journal Entries First, create two accounts Due from factor (reserve) Loss on factoring (factor s fee) Journal entries for $10,000 factored receivable with an 80% advance at 7% cost: Cash 8,000 Due from factor 1,300 Loss on factoring 700 Accounts Receivable 10,000 Total 10,000 10,000 Then once the customer makes full payment and factor returns reserve, enter the following: Cash 1,300 Due from factor 1,300 Total 1,300 1,300 Net effect: $9,300 cash, $700 fee expense. Pegasus is a budding business and must operate on a fiscally conservative shoe string budget. It does not have dedicated resources for receivables management or collections, so uses factoring as back office support. Non-recourse factoring is safer for Pegasus, which could not afford to absorb a $10,000 loss if GreenMarket suddenly went bankrupt or decided not to pay. Accounting for Recourse Factoring ABC wholesaler just received a shipment of widgets from Supply Side, which it then sold to RetailMeNot for $100,000. RetailMeNot is a large chain with good credit standing and a solid payment history, but they rarely ever pay ABC before 45 days. Yet Supply Side expects payment in 10. ABC chooses recourse factoring to get the majority of RetailMeNot s payment now.

4 A factor agrees to advance ABC 85% of the invoice ($100,000 * 85% = $85,000) with a 3% fee ($100,000 * 3% = $3,000). Under Generally Accepted Accounting Principles, sellers must estimate their monetary recourse liability at time of sale. ABC anticipates a $5,000 recourse obligation, meaning it expects $5,000 of the receivable will be uncollectable. If RetailMeNot pays in full, the reserve is calculated by subtracting the fees from the invoice balance ($15,000 - $3,000 = $12,000). If RetailMeNot fails to pay the $5,000 as expected, that amount is subtracted from the reserve ($12,000 - $5,000 = $7,000). With Recourse Journal Entries Create three accounts: Due from factor (reserve = total invoice minus advance and fees) Recourse liability (estimate of uncollected receivable) Loss on factoring (factor s fee PLUS recourse liability) Journal entries for $100,000 factored receivable with 85% advance at 3% cost with $5,000 estimated recourse: Cash 85,000 Due from factor 12,000 Loss on factoring 8,000 Recourse liability 5,000 Accounts Receivable 100,000 Total 105, ,000 If RetailMeNot does not pay the doubtful invoice amount, then ABC has to buy it back from the factor, and the factor will reduce the reserve by the unpaid amount ($12,000 - $5,000 = $7,000). Cash 7,000 Recourse liability 5,000 Due from factor 12,000 Total 1,300 1,300 Net effect: $92,000 cash, $3,000 fee expense, $5,000 accounts receivable written off. ABC recouped $92,000 of its $100,000 receivable. $85,000 immediately, and $7,000 after 45 days. Recourse factoring is sufficient for ABC Wholesaler, because it does not need the added security of non-recourse factoring. ABC is an established company with a strong customer base. Receivables are primarily on time, but extended payment terms are too difficult to manage when suppliers want to be paid much sooner. In the event of nonpayment, ABC is fluid enough to handle the loss.

5 Who Factors? Companies of all sizes and industries choose factoring as a quick way to get cash, but factoring companies notice higher adoption in certain areas. For instance, businesses in the freight, wholesale, staffing, manufacturing, and energy-related industries find factoring particularly useful because of the large up-front costs they incur. Factoring is also widely used by start-up ventures and growing organizations that don t have the cash flow to afford AR staff or capital to secure a business loan. The delay between sale and collection can be devastating for small businesses that need more working capital to function. Benefits The key benefit of factoring is that it provides an instant boost to cash flow. Many businesses choose factoring because it eliminates the several months waiting period for invoice payment and is relatively easy to obtain compared to a loan or a line of credit. And since factoring is based on sales instead of net worth, advance income grows as sales increase. Additional benefits of factoring: Get paid in as little as 24 hours Provides back office support Frees up cash to pay vendors or reinvest Frees up collections resources Does not show up as debt on balance sheet Evaluates customers credit and payment histories Includes extensive reports on customers and status of receivables Factoring allows many companies to expand their customer base because it provides the security to take on larger orders with confidence. A regular advance/reserve schedule means they can synchronize revenue/expense cycles and manage receivables more efficiently. Drawbacks Cost - Because factors assume risk and provide funds quickly, the process is not inexpensive. Cost is the most often cited drawback of factoring, but if you need money quickly and cannot obtain a traditional loan, it may be a good choice. Even if you can obtain a loan, factoring is often less expensive and lower risk. Liability - Recourse (and certain non-recourse) factoring agreements leave clients on the hook for unpaid invoices. Thus, companies should only use factoring as a way to boost cash flow, not to go after old or uncollectable invoices. Customer Relationships Factors work directly with the customer s accounts payable department, which may upset some customers who prefer to work directly with the client company. Customers may also interpret factoring as a sign of debt or liquidity problems.

6 Is factoring the same as AR-based financing? No. No debt is assumed by factoring. In accounts receivable financing, a bank or lending company sets up a revolving line of credit, using the receivables as collateral. The client still owes the lender for the invoice amount once it has been paid. Factoring differs from commercial lending because it is a sale of assets not a loan of money. In accounts receivable financing, no sale occurs. The company still owns its invoices. They are still responsible for collecting payment and maintaining customer relationships, whereas a factor will typically take over those duties. And unlike with traditional financing, factors determine eligibility by the customers financial standing, not the client s.