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Factoring of Accounts Receivable

By Yuriy Smirnov Ph.D.

Definition

Factoring of accounts receivables is a way of raising funds to meet emerging working capital needs. A business sells its accounts receivable to a financing company on a recourse or nonrecourse basis at some discount, usually 10% to 30% of the invoice amount. In other words, factoring helps convert accounts receivable to cash immediately.

A factoring agreement is a contract between a financing company called a factor and a business. It can be either a one-time deal or a long-term agreement, where all existing and new receivables are refinanced under a credit line with a set limit.

As a rule, a factoring agreement assumes notifying the debtor with a Notice of Assignment. This notice serves to inform a debtor about invoices factored and updated payment details, but a factoring agreement can also be confidential. In such cases, the debtor is not notified about invoices factored.

Types of factoring

A recourse factoring agreement means that the seller of accounts receivable is liable for paying damages to a factor if a debtor will be unable to pay an invoice on time. In other words, the factor doesn’t absorb credit risk as a whole but spreads it to the company.

By contrast, nonrecourse factoring means that credit risk is taken fully by a factor, i.e., the seller of receivables isn’t liable for paying any damages if the debtor fails to pay invoices on time. This type of factoring agreement assumes that the factor should assess credit risk carefully before entering into an agreement and refuse if the credit risk is unacceptable.

Factoring process

The factoring process after the initial account setup can be described as follows:

Factoring of accounts receivable

  1. A customer of a factoring company sells goods on credit to its client. Until the invoice is paid by the customer, it is the debtor of the company.
  2. The customer submits the new invoice to the factor for approval.
  3. The factor pays the advance to the customer if the new invoice meets its criteria. The advance rate is usually 80% to 90% of the invoice’s face value. Please note that the advance rate can vary significantly depending on customer and debtor creditworthiness and the industry represented by the factoring of accounts receivable. At the same time, the debtor is notified that the factoring company is now managing accounts receivable.
  4. When a factored invoice is due, the debtor pays its face value to the factor.
  5. At the final stage, the factor pays the rest to the customer less the factoring fees applied.

Example

Retail-X LTD has reported annual credit sales of $18,250,000 and days of sales outstanding of 50. The management of the company is considering the factoring of accounts receivable as a source of short-term financing. The conditions proposed by a factoring company are as follows:

Let’s assess the cost of factoring of accounts receivable.

We can compute the average accounts receivable using the days of sales outstanding (DSO) formula.

DSO =  Average Accounts Receivable
Daily Credit Sales
Daily credit sales =  $18 250 000  = $50,000
365

Average accounts receivable = 50 × $50,000 = $2,500,000

Retail-X LTD has two components of factoring costs:

  1. Factoring fee
  2. Interest expense for money advanced

Factoring fee = $18,250,000 × 2% = $365,000

Average advance = $2,500,000 × 80% = $2,000,000

Interest expense for money advanced = $2,000,000 × 15% = $300,000

Thus, total factoring costs are $665,000 ($365,000+$300,000), and the effective interest rate is 33.25%.

r =  $665,000  = 33.25%
$2,000,000

Advantages and disadvantages

Advantages

  1. Better solvency and turnover ratios.
  2. The cash flow of a customer becomes more steady and predictable.
  3. Factoring without recourse means that the factor takes full credit risk, so the customer avoids bad debts.
  4. Customers of a factoring company reduce costs of the credit department.
  5. Factoring companies have greater experience in assessing credit risk, so their customers improve debtors’ profiles and avoid risky credit sales.
  6. Compared with debt financing, factoring of accounts receivable doesn’t lead to an increase in liabilities, so the debt-to-equity ratio remains unchanged.

Disadvantages

  1. Factoring costs are usually higher compared with other types of short-term financing.
  2. Factored accounts receivable can’t be pledged as collateral to secure other loans.
  3. If an unexpected increase in credit risk occurs, the factor can reduce the advance rate as well as set lower limits on the maximum credit line, which can cause an unexpected decrease in cash flow.
  4. Factoring with recourse means that a customer is liable for paying any damage to a factor if a debtor fails to pay the invoice on time.
  5. Some debtors are suspicious of factoring and prefer to avoid it. Moreover, an aggressive collection policy of a factor may cause its client to lose customers.
  6. It takes about 30 to 60 days to terminate a factoring agreement.
  7. In case of a dispute between the supplier and the buyer or when returning the delivered products, the supplier is liable for paying any damages to a factor.