Factoring can be of great help to companies that at a given moment do not have the ability to keep the implementation of a credit department or portfolio collection within their expenses.
Factoring involves the direct sale of accounts receivable to a factor or other financial institution. Although factoring is the primary factoring institution, some commercial banks and commercial finance companies also factor accounts receivable.
Accounts receivable factoring does not really imply a short-term loan, but it is similar to accounts receivables as collateral.
The factor
It is a financial institution that purchases accounts receivable from companies. The factor generally accepts all credit risks related to the accounts it purchases.
A factor obtains its operating funds through the sale of capital for debt and capital contributions.
The factoring arrangement
A factoring arrangement is extended by establishing the exact conditions, charges and procedures for factoring. Normally, companies that make this type of arrangement do it continuously, selling all their accounts receivable to their factor. The factoring agreement covers the processes of:
- Selection, Notification, Lack of resources, Factor reserves, Payment dates, Advances and surpluses.
Selection:
A factor selects the accounts that you are willing to buy, choosing only those accounts that you think are acceptable credit risks.
Notification:
Factoring is normally done based on a notification, this is because payments are made directly to the factor. Customers whose accounts have been factored; they may simply not receive direct notification that their accounts have been factored, they may be asked to write checks in favor of the factor.
The degree of reserve regarding this arrangement, depends in part on the company against the expectations it has of how its customers will take the fact that their accounts have been factored. The required degree of reserve is incorporated into the factoring arrangement.
Factor
The factor makes the credit decisions of the company, since this guarantees the acceptability of the accounts
Lack of recourse: This means that the factor agrees to accept all credit risks; If the accounts you have purchased turn out to be uncollectible, the factor must assume the losses.
Factor Reserves: After a factor selects the accounts to be included in a factoring arrangement, a certain percentage of the total accounts is set aside to cover any returns or discounts on merchandise sold. The factor normally maintains a reserve of 5% to 10% on the factored amount to protect against such situations.
Payment dates: A factoring arrangement runs between the factor and the company. The arrangement not only establishes the accounts to be factored or the criteria for continuous factoring, but also indicates the payment dates of the accounts within the factoring. The factor is not normally required to pay the company until the account has been collected or until the last day of the credit period arrives.
Advances and surpluses: The factor establishes an account similar to a bank deposit account for each of its clients. As payment is received or due, the money is deposited into the company account. If the company leaves the money in the account, there is a surplus on which the factor must pay interest.
In many cases, the company may need more cash than is available in their account, to supply the company with immediate funds the factor can make advances, against accounts receivable and represent a negative balance in the company account.
Accounts are sold at a discount since the factor accepts credit risk rates and generally cannot charge the borrower anything if an account turns out to be bad
Factoring costs
Factoring costs include commissions, interest on advances and interest on surpluses.
Commissions: These are the payments that are made to the factor for the administrative costs of verification and collection of credits, as well as for the risk that it assumes when buying accounts without recourse. Normally factoring commissions are set at a percentage of 1% to 3% over the nominal value of factored accounts receivable.
Interest on advances: The interest charge imposed on advances is generally 2% to 4% on the prime rate. It is imposed on the real amount that is advanced, paid in advance, thus increasing the effective cost of the loan.
Interest on surpluses: The interest paid on surpluses or positive account balances that remain in a factor is generally 0.5% per month. This is stipulated in the factoring arrangement.
Advantages of factoring
- The ability it gives the company to immediately convert accounts receivable into cash. They do not have to deal with the collection of accounts. When the company receives an advance, it does not have to make any payments. Once the factor collects the account or your payment obligation expires, you simply retain the money. It ensures a known pattern of cash flows. It simplifies the planning of the company's cash flow. If it is continuous, within the company, a factoring arrangement, you can eliminate the credit department, collections department and some administrative expenses.
Historical approach
Factoring initially started in the textile industry as a result of the long credit periods required by textile buyers.
Each factoring arrangement between the company and the factor is unique, since the conditions are set between the two parties and depend on the arrangements that they consider most beneficial for each one.
