A Look At How Invoice Financing Operates
Factoring receivables, or accounts receivable factoring, involves a commercial firm selling its debtors (accounts receivables) to a factoring firm for a price to be paid immediately but less than the book value of the debt. The drawback of invoice factoring for the commercial firm is that it receives only a fraction, or factor, of the full book value of its accounts receivable. On the other hand, the benefits for the commercial firm include receiving the price in cash immediately, improving its working capital flow, and it avoids the risk of debtors defaulting on their payment.
For example, a commercial firm has an accounts receivable balance of $10,000 with an average credit period of 30 days. That commercial firm may be offered $9,000 for those receivables by a factoring firm, representing a factor of 0.9 or 90 percent. If this offer is accepted, the receivables are then owned by the factoring firm and it has the task of collecting the $10,000 amount from each of the individual debtors.
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In the above example, the $1,000 gap between the book value and price paid for the receivables represents the discount required to be offered by the commercial firm in order to attract the factoring firm as a buyer. The size of the discount mainly reflects the risk of default by debtors, the time cost of money and a profit margin for the factoring firm. Each of these three points can be considered in more detail.
Default by debtors is a cost incurred by the factoring firm. If it experiences an 8% non-payment rate it collects $9,200, not $10,000, from debtors over the credit period. Allowing for this default cost, the gross profit earned by the factoring firm is $200 divided by $9,000 equals 2.2 percent monthly (30.2 percent yearly compound).
The time cost of money refers to the risk-free opportunity cost incurred by the factoring firm. As a result of investing $9,000 to purchase the accounts receivables, the factoring firm has foregone the opportunity to invest that $9,000 in a short term money market account based on risk-free government securities at an interest rate of, say, 0.5% per month (6.2% per annum). Accordingly, by purchasing the receivables from the commercial business, the factoring firm has foregone the opportunity to earn $45 per month risk-free.
The factor firm has, in effect, swapped a risk-free $45 profit for a risky outcome that may even be a loss. As it happens, in the above example, this risky outcome turns out to be a $200 profit. By not accepting a risk-free $45 the factoring firm earns an incremental $200 – $45 = $155 profit. This incremental profit represents the reward for carrying the risk of default by debtors. It translates to $155 / $9,000 = 1.72 percent monthly or 22.7 percent yearly.
To earn this incremental 22.7 percent yearly profit, the factoring firm has to accept the risk of an infinite number of possible outcomes, especially losses. For example, if the non-payment rate by debtors had of been, say, 12 percent rather than 8 percent, then the factoring firm would collect only $8,800 at the end of the 30 days and incur a loss of $200 instead of a worry-free profit of $45.
Businesses seeking asset based lending will be requested by the factoring firm to complete a client profile. In collecting this information, the main task of the factoring firm is to form a broad view of the overall credit worthiness of the customers of the business. The client profile will request basic information like the name of the business, its address, the nature of its activities and, importantly, an aged accounts receivable report, credit limits and other basic data about the customers. Ultimately, the firm will assess the credit risk of customers independent of their history with the business.
