What is Factoring?
David M. Morrison, B.A., LL.B.
President, Morrison Financial Services Limited
As a source of funding for the day-to-day operations of a business, factoring is little known in Canada and widely misunderstood by those who know only a little about it. This is largely due to idiosyncrasies in the development of the financial services industry in Canada, and to the fact that at least two distinct products, both involving accounts receivable management, are often lumped together under the broad heading of “factoring”, even though they are actually different. One has to do with the provision of financing to assist businesses through periods of rapid growth and in meeting other strategic objectives. The other is a form of credit insurance, coupled with a package of administrative services.
What is Factoring?
In its purest form, a factoring transaction is the purchase of an account receivable. The vendor is usually a business with an immediate need of cash. The business has an entitlement to cash in the form of an account receivable, but, in accordance with ordinary commercial terms, that entitlement may not be realizable for 30 to 60 days or more. By factoring (selling) the receivable, the business is able to realize the cash immediately; the receivable then becomes the property of the purchaser, the factoring company, which will administer it to collection.
The purchase price in a factoring transaction is usually calculated as the face amount of the receivable, less a small discount. The discount represents the factoring company’s administration and financing fee, which it recovers when the receivable is collected at its full face amount.
While not commonly labeled as such, many everyday transactions are forms of factoring. For example, a receivable is usually factored every time a consumer uses a credit card. The credit card company pays the retail establishment a discounted amount, and assumes the responsibility of collecting the full transaction amount in due course from the cardholder. Certain chequing, coupon and guarantee transactions may also be forms of factoring, but it is not these types of factoring that are the focus of this section. Our concern here, rather, is with factoring as a financing tool for small and medium-sized companies, and with distinguishing the different products which the term “factoring” is often used to describe.
Factoring as a Tool to Finance Growth
Perhaps the best way to focus one’s understanding of when factoring may be the answer to a financing problem is by reference to a simple example.
Our fictitious businessman, John, has just started a business importing widgets, using $70,000 in cash which he had saved from his previous employment. He is confident that there will be good demand for his product and that he can access high gross margins of 30 percent or better.
As it turns out, John’s assessment is right- too right! In the first week he receives an order from Company X for $100,000 in widgets, and he is able to fill this order using his $70,000 of start-up capital. After shipping, he invoices Company X for $100,000 and books a profit of $30,000. The problem comes in the second week when Company Y, to whom he had also made a sales presentation, places an order – an even better one for say, $135,000 – and they want the goods right away. John is anxious to fill this order, but he cannot – he is out of cash. His $70,000 of capital was fully deployed in the sale of Company X and his foreign suppliers are allowing him no credit. It is true that Company X now owes him $100,000, but by normal invoice terms he is not likely to receive payment for 30, 60, or even 90 days. What can John do?
At this stage, approaching the bank for a conventional line of credit is not likely to be the solution to John’s problem. The bank would likely decline his application in view of the business’s limited history and lack of a proven track record. In addition, asset margining limitations and other balance sheet ratios which banks normally apply to such credits would likely preclude a favourable response. Even if the bank were inclined to grant the credit, the response and implementation time would typically be at least two to three weeks, and likely more, whereas John’s need is immediate.
Suppose, however, that John could sell the $100,000 receivable due from Company X in exchange for $94,000 in immediate cash. His profit on the Company X transaction will in effect be reduced from $30,000 to $24,000. But John could then apply the $94,000 in immediate cash to complete the $135,000 sale to Company Y, and thereby realize an additional gross profit of $41,000.
Factoring allows him to do this, producing a “win-win” situation for both sides. The factoring company receives a good rate of return on funds deployed in a short-term current asset transaction, while John enjoys gross profits much greater than he otherwise would have been able to achieve. Moreover, the very same dynamic could again be brought in to okay should John receive another order before he has collected from Company Y, and then again after that, providing John with an ongoing source of working capital throughout the high-growth period.
This, in essence, is what factoring is all about – enabling small and medium-sized companies to achieve rates of growth which they otherwise could not achieve, due to a lack of operating cash or credit. It is not designed for those who have sufficient cash or credit resources to take advantage of all available opportunities, nor is it cost effective when used casually as a method of accelerating receivables where there would be no opportunity cost in simply waiting for payment.
Creative Applications of Factoring
While factoring is most commonly seen as a method of financing growth, there are situations where it can be applied creatively to achieve other strategic goals. Essentially variations on a theme, a couple of examples will suffice to demonstrate this point:
- The leveraged buy-out of a partner
Tom and Peter are partners in a business, with Tom owning 60 percent and Peter owning the remaining 40 percent. The business has $1,300,000 in good quality receivables. Under a predetermined formula or agreement, which takes into account other assets and liabilities, Tom can buy out Peter’s share upon a lump sum payment of $300,000. Tom factors a portion of the receivables to raise some or all of the $300,000 to close. Tom must be careful to allow sufficient working capital to operate the business after closing. If collections on the remaining $1,000,000 of the receivables will not be sufficient, ongoing factoring will be helpful in the period following.
- Purchase back of assets from a receiver
John ran a business for many years, with a strong clientele and good receivables. Unfortunately, the company borrowed heavily to support a plant and equipment expansion just prior to a devastating recession wherein business dropped off. The result was debt of $4,500,000 which the company could not maintain and the receivership ensued. While the receiver was in possession of the plant and equipment, John asked if he could rent the assets on a month-to-month basis under a new company. No other source of income for the property being evident, the receiver agreed, and John resumed business with his old clientele, free of the previous debt burden and able to create new, good quality receivables.
After a year or more, the receiver is still unable to sell the property. John puts in an offer at $1,600,000, which is accepted. A term lender agrees to provide $1,200,000 of the closing amount. John factors $425,000 of receivables in the new company to raise the rest. As in the example, above, John must be careful to allow sufficient working capital to operate the business after closing. If collections on the remaining receivables will not be sufficient, factoring will ne of continuing benefit.
Criteria Generally Applied by factoring Companies
Unfortunately, not every small or medium-sized company has access to factoring as a means of financing growth or achieving other strategic goals. Most factoring companies apply a rather restrictive set of criteria in determining whether or not a potential client’s receivables qualify for purchase.
- Unconditional rights of payment only
Factoring companies will generally purchase only “receivables”, defined as rights of payment where the underlying goods or services have been fully performed and accepted by the indebted party, so that the money is owed without conditions or set-off.
- Creditworthy payor
The indebted party, to whom the factoring company will ultimately look for payment, must be creditworthy, which generally means government and large companies. Most factoring companies refuse invoices in distressed industries or industries such as construction, where collections can be a problem, often because of disputes.
The amount due must be independently verifiable by the factoring company by reference to supporting documentation and, in many cases, through actual contact with the indebted party.
The indebted party must be irrevocably instructed by the company selling the receivable that payment is to be made directly to the factoring company. In many cases, the factoring company will want the customer to acknowledge receipt of such instruction to ensure that the appropriate procedures for re-direction of the payment have been effected.
It is rarely, if ever, that a prospective client approaches a factoring company with such a level of understanding that 1, an unconditional right of payment from 2, a creditworthy payor, which is 3, verifiable and 4, controllable is immediately offered up for sale. More typically, the client describes in general terms a particular financing or cash flow problem, which the factoring company must interpret and analyze to see whether a factoring solution is available. It is here that factoring companies can differ measurably in practice and procedure for, while the four criteria set out above provide the essential framework for analysis, they are more guidelines than strict criteria.
What is meant, for example, by a receivable being independently verifiable? One might think that a review of the underlying purchase order and bill of lading would be satisfactory, and in certain circumstances, it might. But clearly this would be far from sound verification, for all one could tell from such documents is that something was ordered and something delivered. One could not determine whether what was delivered actually complied with the purchase order. Relying on that verification alone, the factoring company could be setting itself up to be caught in the middle of a trade dispute between its client and its client’s customer. It would perhaps be better to require an acknowledgement in writing from the customer that the money is owed and will be paid in due course. Often, however, such a requirement will be impractical.
Similar gradations of meaning pertain when one considers the unconditionality of a payment, the creditworthiness of the payor, and even the controllability of the payment in different circumstances. Consequently, in order to achieve measurable volumes, factoring companies are generally forced to assume varying degrees of risk in their dealings. Over the years, certain tools have been developed, which are commonly used in the management of such risk. Once again, it is here that individual factoring companies can differ measurably in practice and procedure.
Risk Management Tools in Factoring
- General Financial Review
A factoring company will almost always commence its relationship with a prospective client by trying to gain a general understanding of the client’s business and why financing is deemed necessary. This will normally be followed by a review of recent financial statements, including an aged listing of the client’s receivables. These steps will assist the factoring company in deciding how flexible to be in the application of its general criteria.
It is important to note that, in conducting its financial review, the factoring company is not holding the client up to the standards normally required by conventional bankers. Rather, it will usually be looking for certain specific indicators – the business has a clearly demonstrated need for the transaction, the business has some real substance, and the business is not hopelessly insolvent. The factoring company must also ascertain who might already have a charge against the receivable under pre-existing security, as such creditor’s consent to the transaction will be necessary. Finally, the factoring company must satisfy itself that no threat exists of government authorities issuing indiscriminate third-party garnishments of receivables when an audit determines that taxes are in arrears.
As a general rule, one might say that the stronger the evidence that a clearly creditworthy party is bound to pay an invoice, the less the factoring company will be concerned about its own client’s overall financial strength. Unlike a lender, a factor, in a transaction that meets all criteria, is not really advancing credit to its client. It is assuming the risk of credit that the client has already advanced to another, i.e., the client’s customer. Theoretically, once the receivable purchase is completed, it should not matter what happens to the client; the invoice should still be collectible. In practice, however, the insolvency or disappearance of the client prior to collection may, for a number of reasons, increase the factor’s risk substantially.
- Specific Due Diligence
Along with the completion of its general review, the factoring company will conduct due diligence with respect to the specific receivable or group of receivables it is being asked to purchase. This will always include a review of supporting documentation such as contracts, original purchase orders, bills of lading, and invoices. In addition, it may include anything from verbal confirmation with the debtor’s accounts payable department to a requirement of an actual written acknowledgement from the debtor that the money is owing, without condition or set-off, and will be paid within a certain time period.
A very common method deployed by factors to reduce risk is the retention of a right of recourse against the client if, after a certain period of time, the receivable remains uncollected. A factor will almost always retain a right of recourse where its ability to verify the transaction is limited or the creditworthiness of the debtor is deemed weak. The right of recourse will also remain where it is a trade dispute that is interfering with payment or a misrepresentation was made by the client.
Many factors advertise themselves as “non-recourse”, meaning that they relinquish the right to ask for payment back from the client. Usually, however, this means that the factoring company restricts itself to only the highest quality credits (i.e., government and “blue chip”) where the obligation is acknowledged unconditionally by the debtor in writing. To say that there will be no right of recourse in such situations is nebulous, since the likelihood of uncollectibility from the debtor is insignificant.
The concept of “non-recourse” factoring is really more applicable to the activity known as “credit factoring”, discussed in more detail below.
- Holdback or Reserve
Where a factor feels confident about the overall collectability of an account, but is uncertain that precisely the full amount will be received, or is concerned that payment may take longer than expected, it is commonplace to require a “reserve” or “holdback”. The factor does not advance the full amount of the receivable net of its discount fee, but rather holds back an additional amount to cover a shortfall in payment or interest charges in the event that collection is outside the expected period. Upon collection of the receivable, the reserve or holdback is remitted to the client, less the shortfall or interest charges, if any.
Some factoring companies have standard holdback or reserve policies, but, on an industry basis, there is no such thing as a normal holdback or reserve amount. It may be one percent or it may be fifty percent or even more. It all depends on what is motivating the factor to require a holdback or reserve in the first place.
- Industry Specialization
Factoring companies often develop areas of expertise in specific industries. With a good knowledge of the key players and the detailed “ins and outs” of how a particular industry works, the factoring company will often feel comfortable doing transactions which another might not do or even consider. As such, in searching out a factor, the prospective client is wise to investigate whether or not there is a company that specializes in the particular industry.
- Collateral Security
The practice of taking collateral security, such as a real estate mortgage, a general charge against the client’s business assets, or personal guarantees in support of a right of recourse, varies greatly among factoring companies. Many are not equipped to implement such security in a cost-effective manner, and thus limit themselves to only transactions where they can feel comfortable without such security. Some, however, are willing and able to take collateral security in appropriate cases, with the result that there is greater flexibility and the client is afforded a wider latitude in the determination of whether a particular request is acceptable.
Discount Rates and Fees
The amount charged by factoring companies for the discounting of a receivable usually ranges between 4 and 10 percent of the face value of the invoice, with 6 percent being widely regarded as the norm for invoices due 30 to 60 days from the date of purchase. This means that, in order for factoring to be viewed as a viable option, the client must enjoy fairly good gross margins in its business.
A discount rate of 6 percent on invoices factored should not, however, be confused with a cost of 6 percent of total sales; for most clients will not, and should not, factor all of their sales. Rather, they will use factoring selectively only as needed to take advantage of opportunities that emerge from time to time, opportunities where the result would be a net gain after the cost of factoring.
It should also be understood that the factoring fee is not in any sense of pure financing charge. By its nature, to be done with any measure of comfort on the part of the factor, the purchase of a receivable is a relatively time-consuming and expensive process, involving ongoing due diligence and management of the collection process. Moreover, marketing to, and standing ready to serve, a relatively narrow segment of the overall business community is also expensive.
An approach which evaluates factoring on the basis of the gross annualized rate of return to the factoring company is therefore faulty. The proper comparison is in the cost-benefit of doing or not doing the transaction, taking into account the cost of the next best alternative, assuming an alternative exists.
Where an alternative does exist, it will likely be in the realm of venture capital or merchant banking. By contrast to factoring, the negotiation of a venture capital or merchant banking deal is a much more time-consuming and tortuous process, and invariably involves a substantial dilution of the borrower’s equity in favour of the lender. In this sense, although the capital raised may be more “patient”, the true overall cost is usually greater than in factoring Neither of these alternatives, moreover, is really designed to address short-term working capital needs; generally a relatively large transaction size, for a considerable term of three to five years or more, is necessary before a venture capitalist or merchant banker will even consider a financing request.
Procedures in Factoring
The specific steps followed to complete a factoring financing arrangement are typically as follows:
- Application to factor, and agreement reached in principal;
- Due diligence completed;
- Financing agreement completed and acknowledged by both parties;
- Collateral security executed and reqistered;
- Verification and acknowledgement by customer of specific receivables to be financed;
- Completion of specific assignment agreement for each receivable, see sample attached; and,
- Advance of funds.
Some factoring companies will, in certain cases, provide services related to invoice discounting designed to assist the client in advancing a transaction to the invoicing stage, whereupon the receivable will be factored. Generally, these services are in the nature of supplier guarantees, including the posting of letters of credit on behalf of clients in appropriate circumstances. For lack of a better description, these services might be called “near-invoice” discounting because, in all cases, the client will be near the point of having an unconditional right of payment represented by an invoice, but not quite there yet.
An example of how a supplier guarantee transaction might work is as follows. Harry is a Canadian distributor of widgets which he imports from a company in the United States. He receives an order for $100,000 from a creditworthy potential customer. He can purchase these widgets for $70,000, but his supplier is reluctant to ship such a large quantity over the border without having an absolute guarantee of payment. The factoring company solves this problem by taking assignment of Harry’s purchase order and purchasing (factoring) in advance the ultimate invoice in the standard manner. It then provides the supplier with its written guarantee that payment will be made upon shipment of the goods as ordered. If necessary, this guarantee is rendered as a formal letter of credit naming the supplier as beneficiary.
In completing this type of transaction, the factoring company will want to be careful that its guarantee or documentary credit can only be called upon after the satisfactory shipping of goods as ordered. Due diligence might thus include anything from retaining a knowledgeable agent to inspect the goods to requiring written acknowledgement of acceptance from the ultimate buyer. In addition, the factor may wish to control shipment to ensure that the goods got to where they were supposed to go. How involved the factor actually becomes will depend on the strength of its recourse and level of confidence it has in the client to complete the transaction successfully.
In essence, however, this sort of transaction involves no greater risk than the typical invoice discounting transaction. The factor incurs no cost or liability until it has a corresponding right for a higher amount from the ultimate customer who, by definition, is creditworthy. The difference is that the obligation to pay is made in advance. And, where a letter of credit is used, the mechanism for the factor’s payment to its client – or to be more precise, on behalf of its client – is there in support of that obligation.
At the outset of this section, it was noted that there is considerable confusion within the business community about exactly what factoring entails. The reason for this confusion is, in part, due to the fact that certain related but distinctly different services have come to be known as “factoring”. Thus far we have discussed factoring in its purest form – the purchase of invoices at a discount – or, “invoice discounting” as it is often referred to in more specific terms. Now let us examine a different situation.
Consider the position of a clothing manufacturer, whose plant and offices are located in Toronto, but whose product is sold in hundreds of small and large independent retail stores across the continent. Typically, such distribution is effected by the establishment of a network of manufacturer’s sales agents to represent the product in each geographic area. The agent in each area, selling from samples, takes purchase orders from retailers wishing to stock the company’s product, and transmits them to the manufacturer for shipment. Often a completed credit application form must be submitted with the first order.
For the manufacturer in this situation, managing credit risk in any meaningful way is a difficult if not an impossible task. How is it to be determined, with the limited information available, whether a small boutique located hundreds or thousands of miles away is a good credit risk? Yet, requiring cash on delivery is often impractical in the context of selling to retailers. Even determining how much credit a large and well-known company should be granted can be difficult.
For many decades now, there have existed throughout North America and worldwide companies whose services are designed to assist manufacturers, and others selling at the wholesale level, with this problem. These companies provide, on a selective basis, a guarantee to their clients that invoices for goods satisfactorily delivered will be paid. The principal condition for obtaining such guarantee is that the client must process all of its invoices and collections through the guarantee company. The guarantee company thus becomes the manager of what is collectively a large portfolio of receivables on behalf of its many clients.
The processing of invoices and collections through the guarantee company is considered a fundamental part of the service offered by these companies. It includes maintaining the full receivables ledger, posting payments, making collection calls, following-up on short payments and bad cheques, and providing a range of reports. But more importantly, it enables the development over time of a very accurate picture of both general payment patterns within the industries serviced, and the payment patterns of particular customers, small and large, within those industries. Using this information, the guarantee company will set limits on whose credit it will guarantee and for how much.
The fees charged by credit guarantee companies are usually set at a percentage of the face amount of each invoice processed. The percentage ranges from .075 percent of the invoice amount to 2 percent, depending on such criteria as the client’s total volume, number of accounts, quality of accounts, and the average invoice amount. Minimum annual fee amounts and special rates may apply. Fees are ordinarily paid on a monthly basis from the amounts remitted to the client after collection.
Because it includes the processing of invoices and collections, the service of providing credit guarantees in this manner has come to be known as “factoring”. This is notwithstanding that, unlike with invoice discounting, the central purpose is not the provision of financing. It is true that having a creditworthy party guarantee one’s receivables certainly makes them more bankable in terms of their being able to support an application for an operating line of credit. But the credit factoring companies operative in Canada today are not generally in the business of providing financing per se. To the extent that they will from time to time loan money against a client’s outstanding portfolio of receivables, it is usually done as an accommodation to a valued client.
In the United States, the orientation of credit factors is discernibly different. Most companies regard the lending of money against outstanding portfolios of receivables as their principal business and major source of revenue. There are also companies who provide portfolio loans without the credit guarantee, so that recourse remains against the client in respect to any invoice which is loaned against but ultimately proves uncollectible. When receivables management is combined with portfolio lending, whether or not on a recourse basis, we end up with a service which is closely allied to traditional factoring of the invoice discounting variety and can serve much the same purpose. But the two types of factoring are nonetheless different, and it is important for the prospective client to understand the differences if he or she is to be able to evaluate which service is more appropriate and which is more likely to be available as a solution to a particular need.
The reason Canadian credit factoring companies have limited themselves when it comes to financing has to do with a the substantial difference in the conventional banking practices in the two countries and, in particular, with the practice of Canadian banks, wherever possible, of tying up all available assets as security under broad general security agreements. The parceling off of receivables or other specific assets to support outside financing activities of the borrower, although achievable, can be a somewhat complex and cumbersome process in this context.