Details On How Accounts Receivable Factoring Functions
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 accounts receivable 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.
To take an example, a business has a debtor balance of $10,000 with a credit period of 30 days on a time weighted basis. That business might be offered $9,000 for those debtors by a debtors factoring firm, reflecting a 0.9 factor. If the business accepts, the debtors become the property of the debtors factoring firm and it then has the burden of collecting the $10,000 from the debtors.
In this example, the $1,000 gap between the $10,000 book value and the $9,000 price paid for that book value represents the discount accepted by the business for its receivables asset. The size of this discount covers the risk of non-payment or default by debtor customers, time value (cost) of funds and the profit of the factoring firm.
Having purchased the debtors means that defaults by debtors is borne by the factor firm. If it experiences a 8% non-payment rate it collects only $9,200, not $10,000, from debtors over the average 30 day credit period. Allowing for this $1,800 default cost, the gross profit enjoyed by the factor firm is $200 divided by $9,000 equals 2.2 percent monthly (30.2 percent yearly compound).
The time value of money is an opportunity cost for the factor firm since it foregoes the opportunity of earning a risk-free return on the $9,000 it used to acquire the debtors. By using those funds to invest in debtors, the factor firm cannot invest that $9,000 in the risk-free money market deposit. If the interest rate paid on that money market deposit is 0.5 percent each month (or 6.2 percent each year), the factor firm loses a worry-free monthly interest return totaling $45.
The factoring firm has effectively traded a $45 risk-free profit for a profit that has risk. As it happened, this risky profit turned out to be $200. In other words, by forsaking $45 the factoring firm has earned an incremental $200 – $45 = $155 profit. This incremental profit is the reward for bearing the risk of non-payment by debtors. It calculates to $155 / $9,000 = 1.72 percent monthly or 22.7 percent yearly.
To generate this incremental 22.7 percent yearly return, the factor firm has to carry the risk (accept the possibility) of an infinite outcomes, including possible losses. For example, if the debtor default rate had of been, say, 12 percent rather than 8 percent, then the factoring firm would collect only $8,800 during the credit period and suffer a loss of $200 instead of a worry-free profit of $45.
Businesses seeking asset based loans 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.
Discussion | Share Feedback