What Every Commercial Banker Should Know About Factoring

Factoring is a word often incorrectly used synonymously with accounts receivable financing. In Europe, the term “factoring” has become the term for accounts receivable financing in general; but in the U.S., this term refers to a specialized form of financing that involves the actual transfer of the ownership of the receivable to the lender, more accurately known as American Factoring. Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) at a discount. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables, not the firm's creditworthiness. Second, factoring is not a loan but the purchase of an asset (the receivable). Third, a bank loan involves two parties, while factoring involves three.

The three parties involved in a factoring arrangement are the seller, the debtor, and the factor. The debtor owes the seller money, usually from the purchase of goods or services. It is common in business-to-business transactions for a seller to offer terms that allow payment for goods or services at some time after the actual delivery and acceptance of the goods or services. Once the client (the debtor) has accepted the goods or services, the resulting obligation to pay the seller (usually represented as an invoice) becomes a negotiable instrument that can be sold. In factoring, the third party in this transaction, the factor, buys the invoice(s) from the seller, usually at a discount to allow for the factor's return and with a reserve, which is a margin the factor holds back until the receivable is retired by the debtor. Upon receiving payment on the invoice at its full face value, the factor remits the reserve to the seller.

Why would a company want to sell its accounts receivable? The answer is cash flow. Most companies would rather deal on a cash basis, but competition and business tradition usually allow a time gap between delivery and payment, especially in business-to-business transactions. If a company has a gross margin—the difference between the sales price and the cost to produce the good or service—that is high enough and it feels immediate liquidation of the receivable asset will earn more than holding it until it's paid, then it makes sense to turn the receivable into cash and use it to produce more goods and services, or to take advantage of cash discounts with their suppliers.

A bank loan such as a revolving line of credit provides the same advantages, with some distinct differences. First, the bank has a collateral assignment of the receivables but, in factoring, the factor owns them. Thus, the primary focus of the bank lender is the creditworthiness of the borrower, with secondary focus on the debtors responsible for paying the accounts receivable but, in factoring, the factor is more highly focused on the account debtor and less so on the borrower. Second, the bank will generally not lend as much to the borrower, while the total invoices the borrower has drives the amount the factor will advance. Third, while bank borrowing is usually less expensive than factoring, the scope of the service is limited to just lending the money, while a factor tend to provide more value in the relationship; besides granting the credit the borrower needs, the factor also provides credit advice to the borrower, and treasury management services with daily reports on lockbox activity that often can be downloaded directly into the borrower's accounting software. This outsourcing of the accounts receivable management function can be of great value to a small but rapidly growing business.

The community banker should regard the commercial factor as an ally rather than a competitor. Most community bank lenders tend to focus on acquiring borrowing customers without looking at a total relationship so, when a prospect fails to meet the bank's credit qualifications of the bank, the prospect is dropped without consideration of his or her needs in depository, treasury management, and term-borrowing products. If the bank has a relationship with a good factor, however, a prospect with working capital needs that don't fit the bank's lending criteria could be referred to the factor while the bank reaps the benefit of the other needs the prospect has in deposits, term loans, and treasury management. Then, when the prospect grows and improves his or her financial position, s/he may meet the bank's working capital financing criteria and can easily move the relationship into the bank where the prospect now has other products. The same process can be useful for existing bank borrowers who go through some period of crisis in their business; the borrower can be referred to the factor to help get through the crisis and then come back into the bank when the borrower's financial situation improves. Most factors will pay an ongoing fee to the bank for these kinds of referrals.

There are many misconceptions about factoring, although it is an extremely old form of financing. It was first used in the U.S. in the textile industry, which was an industry of small, rapidly growing businesses selling to large retail chains and clothing manufacturers. It was also a common form of financing commerce in England, and some rules for factoring are even found in the Code of Hammurabi, the first set of laws governing commerce in ancient Babylonia. Some of the more common misconceptions about modern factoring are that it is expensive, that it should be a last resort, and that factors are competitors for lending. Let's look at each of these misconceptions individually.

Factoring is expensive. Many bankers, accountants, and attorneys that have limited experience with factoring feel that any means that accomplish the same end, such as deriving cash from receivables should cost the same. Although the discount earned by the factor may seem high from an APR standpoint, the total value of the relationship must be considered. Not only is the seller converting his receivables to much-needed cash—more than s/he would with a bank line of credit, s/he is also getting an outsourced credit department and payment management department. The factor also assumes part of the risk of the debt and so provides intensive credit checking and accounting. Recourse factoring, where accounts that do not pay in a specified period of time are sold back to the original seller, is much less expensive than non-recourse factoring. Recourse factoring will also usually accept average credit invoices, while non-recourse factors will only buy “aces and straights.”

Factors are the lenders of last resort. Just as there are subprime lenders in mortgages and auto loans, there are subprime lenders in factoring, but the majority of factors are very conservative credit-grantors. Their focus is on the seller's clients, and they are very good at determining the creditworthiness of those clients far beyond the abilities of most small businesses. In fact, many large companies use factors at quarter end to “dress up the balance sheet” and show cash, rather than receivables. Many small businesses sell to large businesses that generally take longer terms to pay small vendors for reasons other than credit; the large gorillas pay slowly because they can and factoring gives a small business a tool that allows it to compete for the gorillas' business while maintaining essential cash flow.

Factors are lending competitors. Unless a bank is also in the factoring business, banks and factors are not competitors. Because of regulations and FDIC coverage of their deposits, banks tend to stay in the true lending arena, seeking low-risk loan assets with minimal oversight of the client, while factors are in a very specialized area of trade finance that requires a good deal of oversight. Any bank that is actively pursuing a strategy of increasing their business and industrial banking clients should have a good relationship with a good factor—one that is financially strong, has a good track record of earnings, and most important, has experience in the banking world so they can respect the sanctity of the relationship between a bank and its clients.

Finally, it is important that factoring fits the set of customer circumstances. The seller should be a rapidly growing business with enough margin to cover the factoring cost (taking into account the additional services provided by the factoring relationship) and the ability to deploy the cash to earn more than the factoring costs. A mature business with slower growth is not as good a candidate for factoring services because it should be able to finance its own receivables, either internally or in combination with a bank. There is an old saying in business that “Poor is permanent and broke is temporary.” When “broke” is defined as shortage of cash because cash is tied up in receivables from creditworthy buyers after a rapid upturn in business, then call in the factor. He can make the banker a hero and cement a great relationship between the banker and his client.

About the author: Keary Barnes is a SVP with Catalyst Financial Company, a Houston factoring company that provides factoring services for small to medium-sized businesses in a variety of industries. Catalyst's principals have over 50 years experience in accounts receivable funding. Mr. Barnes is a former Texas Banker working in the Houston and Texas markets in working capital lending, commercial leasing, and treasury management. As a former banker, he understands the relationship between banks and their clients and has been successful in forming strategic relationships with Texas Banks to aid them in their efforts to increase their business and industrial bank portfolios. He can be contacted at:

Catalyst Financial Company
11511 Katy Freeway
Suite 300
Houston, TX 77079
kbarnes@catfinco.com
281-870-9182