Understanding Commercial Factoring and Credit Insurance
If your company suffered a $150,000 loss, and your pre-tax margin is 7.5%, you would have to do $2,000,000 in additional sales to break even. Yet accounts receivable is usually the only major asset not routinely safeguarded against catastrophic loss. This TRM supplement will familiarize you with two traditional methods of sharing the risk of receivable management. With increasing pressure to do more with less, and the need to manage capital as accurately as possible, insight into these methods will help you in your management of credit and receivables.
NOTE: It is important for the credit and accounts receivable professional to be familiar with the concepts of factoring and credit insurance regardless of how successful their companies own operation is. For example, understanding these concepts may help you evaluate your competition in the event they are factored. Today, many commercial factoring and insurance companies have become more customer oriented and creative and can work with the credit professional to complement rather than replace their in-house operation.
Factoring grew specifically out of the need for working funds in some industries, originally, the textile and apparel trades. It provides the means for businesses to convert receivables to cash before they are due without retaining liability for their payment. It had its inception in early American history, when factors acted as commission merchants handling goods on consignment. During the latter years of the 19th century and the early years of the present century, factors began to stop acting as sales agents for their clients. The general factor thus gradually evolved into the modern factor. The great growth of factoring, the entrance of a variety of financing institutions into this field, and the widespread uses of such financing in many different lines of business are all quite recent phenomena, developing since the beginning of the present century.
Among the principle reasons that modern-day companies use a factor are:
- to limit credit and collection expense (including credit losses) to a definite percentage of credit sales
- to reduce credit and collection expense ratio (including credit losses) or obtain a more efficient performance of credit and collection
- to increase sales through credit granting and collection services provided by the factor
- to increase its profits by concentrating on product development, production, and sales
- to smooth the business cycle of highly seasonal businesses which overwhelm credit, bookkeeping and collection staffs during peak season but leave them idle during the slow season
- to handle international trade due to the lack of expertise in house.
In factoring, the accounts receivable are purchased by the factor that assumes the credit risk normally without recourse to the seller. The seller’s customers are notified notification arrangement to make payment directly to the factor or, are not told about the arrangement, and continue to pay to the seller non-notification arrangement.
The business firm entering into a factoring agreement not only contracts to sell its receivables to the factor but also relieves itself of the credit and collection function, including the cost and risk of decision making regarding credit and collections. This role is assumed by the factor for a fee. Under no other method of short-term financing do business firms shift the credit and collection job to the financing institution. When a business is being factored with notification, it shows on its invoices a notice that payment for the goods is to be made to the factor.
The factor approves credit for the client. As the client makes shipments, it sends copies of the invoices and the shipping documents to the factor. It may obtain immediate cash for the full net face value of the invoices (i.e., the gross amount of the invoices less any discounts and allowances granted to the client’s customers) from the factor, minus only the commission for services rendered and a reserve to offset returned goods, merchandise claims, and the like. The remainder due the client is made available at the average due date of the invoices.
When a factor checks credit, it takes over the credit and collection functions of its clients. The clients no longer need to conduct credit investigations and analysis, make credit decisions, keep records of accounts receivable, collect accounts receivable, and sustain bad-debt losses.
When an order is received from a customer, the client calls the factor for a recommendation. The factor usually has a credit file on the account or will set one up when the request is received. The file contains agency reports, memoranda of the factor’s interviews with the principals and the accountant, trade reports, bank investigation, and other information normally contained in a credit file. In addition, there is a record of inquiries on the account, the factor’s current exposure, and the recommendation. If the recommendation is favorable, the factor approves the client’s order.
Purchases Accounts Receivable from Transaction:
When the factor approves a client’s order, there is a concurrent agreement that the receivables resulting from the order will be purchased by the factor. This distinguishes factoring from pledged borrowing. In factoring, title to the claim passes from the client to the factor. In pledged borrowing, title remains with the client. In this way the client is assured of a stated amount of money each time the factor approves an order. There is no need for accounts receivable follow-up or for collection procedures. The likelihood of bad-debt losses is eliminated on approved accounts.
The only exception to this procedure occurs when a client ships an order that has not been approved. In that case, the factor is not obligated to participate in the transaction. The order is shipped at client’s risk. There the factor reserves the right to turn down the receivable arising from that particular transaction or may advance money against it with recourse which makes the client contingently liable on the account.
At any time after the receivable is created, the client may turn it over to the factor. This function of the factor is called cashing receivables, or cashing sales, on an advance basis (prior to maturity) or at maturity.
On an Advance Basis:
Upon the request of the client, the factor advances funds against the receivables that have been checked or approved. This client forwards the invoices and usually receives 85 to 90 percent of the face amount purchased before maturity; the factor holds back the balance for such contingencies as returns and discount, disputed receivables and client’s risk receivables. This provides the funds to the client before the due date of the invoice.
The factor does not advance funds, but remits monthly on the average due date of the invoices bought in any given month.
A factor notifies its customers that their invoices are being sold to the factor each invoice is stamped to that effect. The client’s customers pay directly to the factor who now owns the receivable. In industries such as textiles and apparel, factoring is commonplace. Therefore, client’s customers are willing to deal and cooperate with the factor while submitting credit information and answering collection inquiries.
The factor purchases accounts receivable without recourse to the client, and bears the entire burden of collection and risk of bad-debt losses. This feature is especially attractive to a company that must plan cash requirements very carefully and cannot afford extraordinary bad-debt losses.
The factor purchases accounts receivable with recourse to the client. A client may have made an independent decision to supply merchandise in excess of the limit the factor claimed responsibility for. The factor will work the receivable until a specific date (usually a set number of days) then turn the receivable back over to the client for resolution. There are many “creative” arrangements that can be made on the ground-rules for selling with recourse.
Loans on Inventory:
Along with buying client’s accounts receivable without recourse, factors offer a number of other services. Primarily among these is the lending of money against inventory. This method of secured borrowing is often used by customers to finance temporary needs for working funds. When the client sells the inventory, it turns over the resultant receivables to the factor and liquidates the loan.
Cost of Factoring:
A factor charges a commission or fee for performing the credit and collection function and for purchasing the client’s receivables with or without recourse to the client for bad-debt losses. The factor’s commission for service usually ranges between 75 and 90 basis points of sales, or the net face value of receivables bought over one year. A number of conditions will determine the costs for service such as:
- The nature of the business, including styling considerations, seasonable aspects, stability of products, whether the customer is a manufacturer or wholesaler.
- Annual sales volume of client. As volume increases, the percentage charged will usually decline.
- Average size of order processed. Large orders are no more time consuming to process than small orders and produce more revenue for the factor. Therefore, the factor’s commission rate may decline as the size of the individual orders rises.
- Average annual sales volume per customer. As this figure rises, there is less work and follow-up for the factor, since the client’s business is becoming concentrated in few accounts. The commission rate will tend to decline.
- Credit worthiness of the client’s customers. If the risk is relatively small, the factor’s commission may be lower.
- Client’s selling terms. If they are long, the factor must wait to collect its receivables, this would require a higher fee.
- Other services such as billing, may be provided by the factor that will increase costs and raise the charge to the client.
Additionally, the factor charges interest on funds provided when the receivables are cashed. This borrowing is typical of A/R and inventory financing that will cost between 1% to 4% over prime.
If your company is a U.S. based exporter selling internationally, a factor can help offer competitive open account terms of sale while controlling the risks involved. Factors provide comprehensive credit management, protection against losses, collection services, and working capital to assist international sales growth.
In addition to relieving exporters of the time-consuming administrative burden of approving international credit and collecting sales, export factoring lets exporters safely offer their foreign customers competitive open account payment terms. Most importantly, factors help convert export receivables into cash by advancing funds to you prior to collection.
Export factoring eases much of the credit and collection burden created by international sales. By outsourcing this credit function, you can convert the high fixed cost of operating an international credit department into a variable expense. Commissions are based on sales volume so your costs fluctuate with actual sales, resulting in lower costs for you when your sales are down.
NOTE: It has generally been found that if a company does considerable, consistent international trade, they can develop, with proper training and expertise, a more efficient in-house credit department handling international credit than operating through the use of a factor.
Export factoring provides credit protection for 100% of the value of the invoices billed. Additionally, the factor collects the proceeds from your sales and can assign them to a bank in the U.S. if required. The factor manages the whole process for you; from invoicing through collecting to full financial reporting. Therefore, you are provided with an integrated accounts receivable management system for your international sales.
Many companies use export financing as a method to increase their borrowing ability from their lender since many lenders refuse to lend money against foreign receivables. By having the export receivables factored, the factor purchases the accounts receivable and assigns the proceeds to your bank. Your bank will then be able to lend against those receivables.
Is a Bulk Sale of Accounts Receivable Right For Your Company?
As with all businesses, the need to be more creative has crept into the world of factoring. A new concept that has developed and offered by some factors is a bulk sale of accounts receivable. Reasons a company might consider selling its receivables would be:
- to present a more liquid balance sheet for a quarterly or year-end financial statement
- to meet a lender bank’s clean-up or clean-down requirements
- to have a U.S. subsidiary of a foreign company seek its finances on a stand-alone basis
- to liquefy a company’s accounts receivable to facilitate a merger, acquisition or liquidation.
In general terms, insurance is the transfer of risk from one party to another (an insured to a carrier) for a consideration referred to as a premium. A credit insurance policy specifically insures the extension of credit from one company to another by guaranteeing, according to the terms and conditions of the policy, that the seller will be paid either by the buyer or the insurance company.
Policies can be tailored to meet your specific needs. A general coverage policy can cover shipments to buyers through various combinations of coverage such as:
- blanket limits on all your customers
- coverage on specific customers for specific amounts
- protection for larger accounts only where these customers represent a significant concentration of risk
- or for businesses with large numbers of small balance accounts
- preset limits structured around the credit rating of the Governing Mercantile Agency named in the policy (usually the credit rating agency used in your credit department or industry). This method demonstrates the flexibility of contemporary insurance policies by associating a table of ratings from the “governing agency” with predetermined limits of exposure. These agencies are either non-industry specific such as Dun & Bradstreet or industry specific such as Lyon’s Furniture, Lumberman’s Credit Association or Jewelers Board of Trade.
Cost of Insurance
Insurance costs depend on many factors such as: policy structure, credit worthiness of the risks involved, and the amount of retention of risk assumed by the insured. Typically a policy of domestic credit insurance would range between one tenth of one percent of sales to four tenths of one percent of sales. Additionally, the degree of risk (or quality of the customers); historical loss experience in your organization; current credit extension and collection operating procedures; level of experience or expertise (as evaluated by the insurer) and the concentration or distribution of risk throughout your customer base is considered.
However, as with any insurance product, the quality of what is being insured, will have a bearing on the cost of the insurance. This supports the assertion that insurance should be viewed as a partnership with the credit management objective. Consequently, the better job you are doing, the more economical the insurance is in protecting your company against a catastrophic loss.
Export Credit Insurance
Like factoring, export credit insurance is a specialized line of insurance. These policies cover sales from the United States to countries world wide. Like domestic policies, they cover against the financial inability to repay for goods sold or services rendered. Premiums for export coverage generally run higher and could range from one quarter of one percent to one percent of covered sales. Many companies are finding that requiring Letters of Credit and other cash documents places an artificial obstacle between the buyer and seller, restricting growth. These companies often use credit insurance to offer open terms and be more competitive in the global market place.
The products and services of commercial factors and risk insurers have become more customer oriented over recent years. The need for these lines of business to be more competitive with other types of lenders and financial service providers has generally been good for their customers. Particularly factors have tended to “unbundle” their services which has clearly increased their business by giving their customers more opportunities to take advantage of them without literally substituting their in-house credit and accounts receivable departments for a totally outsourced function.