J.P. MOCZULSKI
Owners of small or medium-sized businesses (SMBs) that find themselves in immediate need of cash to pay suppliers or staff, to take advantage of a business opportunity, or to simply to stay afloat through a downturn, could turn to 'factoring' as an option.
Factoring is the outright sale of your accounts receivable to a factor company, which bears the risk of collection. It is not a process to be entered into lightly.
The selling business is entitled to cash that, at the moment, is in the form of an accounts receivable that may not become cash for 30 to 60 days or more. By factoring, or selling, the receivable to a factoring company (a specialized financial institution), the business can realize the cash immediately.
The receivable then becomes the property of and collectible by the purchaser.
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, recoverable when the receivable is collected at its full-face amount.
Although we do not usually label them as such, many of our 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 from the cardholder. As well, certain chequing, coupon and guarantee transactions are also considered forms of factoring.
Criteria applied by factoring companies
Unfortunately, not every SMB has access to factoring because factoring companies apply very restrictive criteria of acceptability to the offered receivables:
• Unconditional rights of payment.
• Creditworthy payor.
• Verifiable receivables.
• Controllable receivables.
Unconditional rights of payment only
Factoring companies will generally only purchase "receivables" defined as rights of payment, such as 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 must be creditworthy, usually governments and large companies. Most factoring businesses refuse invoices from distressed industries or industries such as construction where disputes can often make collections a problem.
Verifiable
The amount due must be independently verifiable by supporting documentation and through actual contact with the indebted party.
Controllable
The company selling the receivable must instruct the indebted party that payment must be irrevocably made to the factoring company. In many cases, the factoring company will want to be assured the customer has acknowledged receipt of instructions for re-direction of the payment.
A prospective client rarely approaches a factoring company with such a level of understanding of the above factors that a verifiable, controllable, and unconditional right of payment from a creditworthy payor can be immediately offered for sale. More typically, the client describes in general terms a financing or cash flow problem that the factoring company must first analyze and interpret to determine whether factoring is the solution.
Although the four criteria provide the analytical framework, they are more guidelines than strict criteria. Factoring companies are forced to assume varying degrees of risk. Over the years, they have developed tools now commonly used to determine and manage such risk. However, the practices of individual factoring companies can differ significantly.
Discount rates and fees
The amount charged to discount a receivable usually ranges between 4 per cent and 10 per cent of the face value of the invoice, and 6 per cent is widely regarded as the norm for invoices due 30 to 60 days from the date of purchase. This means that factoring can only be an option if the client enjoys good gross margins.
The factoring fee is not in any sense a pure financing charge. By its nature, the purchase of a receivable is a time-consuming and expensive process involving due diligence and management of the collection process. Marketing to and serving a narrow segment of the business community is also expensive.
Special to the Globe and Mail
Excerpts from The Financing Toolkit for Small & Medium Businesses by Gary A. Fitchett, CA, provided by the Canadian Institute of Chartered Accountants. For more information go to www.knotia.ca/store, or www.cica.ca/financing.