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The Cash Factor

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The Cash Factor Finance The Cash Factor B Y J AMES A. WEISEL, CMA, CPA; NEAL H ARM; AND C ASSIE F. B RADLEY, CFP If you used your credit card to buy gas on your trip to the office this morning, then you understand the essential elements of factoring receivables. The credit card, one of the most common modern personal receivable finance vehicles, is similar to commercial factoring. A company sells a product to a customer who agrees to pay at some future time. The com- pany “sells” that receivable to a host bank, which collects the full amount and returns it to the company minus a small percentage. (See Figure 1 for an illustration.) Increased convenience, reduced credit risk, and faster cash flow for the company are the primary motivations. ❶ COMPANY BUYER ❸ ❹ ❷ ❺ ❸ FACTOR Discount Fee Figure 1: Where Does the Cash Flow? ❶ Company sells goods or services to the Buyer on credit for $1,000. ❷ Company “sells” receivable to the Factoring Partner at a discount rate of 2%, $980. ❸ Factor advances 85% of discounted invoice, $833. Factor also sends the invoice to the Buyer. ❹ Factor collects $1,000 from the Buyer. ❺ Factor remits reserve to Company, $147. September 2003 I STRATEGIC FINANCE 1 Table 1: Characteristics of Short-Term Finance Vehicles FACTORING ASSET-BASED LOAN CASH-FLOW-BASED LOAN Security/collateral Assets sold to factor; title and risk Assets used as collateral for loan; Assets may or may not be used as pass to factor title and risk remain with company security, depending on loan risk factors Assets involved Accounts receivable Accounts receivable and inventory Accounts receivable, inventory, prioritized, with machinery, real machinery, real estate, patents, estate, patents, trademarks, or trademarks, or other assets where other assets where value can be value can be determined determined Front-end discount fees Varies significantly, from 0.5% to Typically 0% of asset face value Typically 0% of loan value 5.0% of receivables, depending on average invoice size, risk, volume, and other factors Interest Simple interest based on the Annual Percentage Rate (APR) Annual Percentage Rate (APR) amount of money advanced on the based on prime + % charged on based on prime + % or LIBOR rate invoice from the date of purchase average balance outstanding charged on average balance until collected outstanding 1 Advance rates 75% - 90% of receivables depend- Typically 85% for receivables, 2 ⁄2 — 3 times EBITDA ing on concentration, longevity of 50% for inventories factor-company relationship, and historical dilution rate Accounts receivable Large factors can assume full A/R Borrowing based on certificates of Borrower provides aging of A/R on reporting and management and provide credit risk assets; borrower may need to a quarterly basis management protection provide quarterly audits of secured assets Factoring is defined as the selling of accounts receiv- factoring include credit protection, collection service, and able (A/R) at a discounted amount. Accounts receivable is improved cash flow. See Table 1 for a summary of the a business asset just like a piece of property. Under a principal differences in the three types of lending. lending arrangement, accounts receivable is taken as col- Asset-based borrowing amounted to $343 billion in the lateral against a loan. With factoring, the invoice is sold to U.S. in 2000. Since assets are pledged as collateral, title and the factor. This does not create a loan or an obligation. risk remain with the company. Asset-based loans are typi- On the company’s balance sheet the receivable has cally revolving loans backed by the most liquid company become cash, moving it from a near-liquid to a liquid assets—receivables and inventories. Other assets such as asset. In some instances, inventory and/or equipment machinery, real estate, patents, or trademarks may also be may be taken as collateral. pledged as collateral. The advance rates are typically 85% Factoring differs significantly from asset-based lending for receivables and 50% for inventories. Advance rates on and cash-flow-based loans, and, in today’s business envi- other types of assets vary widely depending on valuation ronment, it may compare favorably to them. Reasons for and risk assessment. 2 STRATEGIC FINANCE I September 2003 Like asset-based loans, cash-flow loans are typically established in a revolving account. Unlike asset-based Table 2: XYZ Company: lending, however, specific assets are not used as collateral. Traditional vs. Factoring Rather, the lender loans the company money based on the company’s assessed ability to generate cash flow from BASIC DATA operations and repay the loan in a timely fashion. In Annual sales $10,000,000 today’s tumultuous economy, many borrowers have seen the sources of cash-flow-based loans shrink considerably. Average DSO 45 days Advance rates on these types of loans have gone from Average A/R balance $1,232,877 four times EBITDA (earnings before interest, taxes, Working capital available depreciation, and amortization) to two-and-a-half to @ 85% advance rate $1,047,945 three times EBITDA in just the last year. Factoring of receivables is a relatively untapped source of financing in the U.S., accounting for $87 billion in TRADITIONAL LENDING 2000. Although widely used in the textile, apparel, carpet, Annual interest @ 4.25% + 1% $ 55,017 and home furnishings industries, factoring hasn’t yet hit Expanded credit collection and the mainstream. It suffers from the perception that only management personnel (2 people, companies about to go out of business use it. In fact, just salaries and benefits) $120,000 the opposite is true. Annual write-off @ 1% of sales $100,000 Factors generally desire long-term relationships with growth companies. They essentially act as outsourcers for Total annual cost $275,017 credit management and collection of receivables. There are several significant advantages over the more prevalent FACTORING asset-based and cash-flow-based lending vehicles. Fees @ 2% of sales $200,000 FACTORING: THE ADVANTAGES Annual write-off $ 0 The advantages of factoring over alternative forms of Total annual cost $200,000 short-term financing include improved cash flow, reduced credit risk, opportunity cost savings, and an improved balance sheet. For example, a company with an average accounts receivable balance of $100,000 and Several potential areas of reduced opportunity costs annual sales of $1 million has days’ sales outstanding exist for companies choosing to factor their receivables. (DSO) of 36.5 ($100,000/($1,000,000/365)). If it were to Factoring offers the service of accounts receivable man- factor all of its A/R with an advance rate of 85% made in agement that will never be provided by a traditional three days, the DSO would be reduced to eight days, working capital loan. A factor’s biggest cost is providing nearly an 80% improvement in cash flow. credit, with larger factors possessing larger credit The company is in business to sell a product or service. resources. In theory, this should mean better, quicker, and The seller usually offers these goods under terms for more cost-effective credit decisions. Much of the evalua- repayment, which creates accounts receivable; the seller tion of a customer’s credit risk is shifted from the compa- has allowed the customer to use its balance sheet to ny to its factor, creating an opportunity to reduce credit finance the goods. and collections department expenses such as wages, bene- Under a traditional working capital arrangement, the fits, and infrastructure costs. seller is a de facto underwriter of its customer base and Let’s compare the potential annual cost of factoring manager of the risk associated with the underwriting and versus a traditional cash-flow-based loan (see Table 2). collection of the obligation. Under a factoring arrange- XYZ Company, a medium-size firm, is experiencing sales ment, the company sells the accounts receivable for growth of $10 million in a new product line with an aver- immediate cash. The underwriting and management of age DSO of 45 days. The company requires $1 million to risk associated with collection is effectively outsourced to support this expansion. the factor, reducing the company’s credit risk. XYZ can borrow the required working capital at prime September 2003 I STRATEGIC FINANCE 3 (assumed to be 4.25% here) plus one percentage point. It other words, a few large-dollar invoices will cost less than a experiences 1% of annual sales write-offs and expands large number of smaller invoices. Clearly, risk assessment, the credit management and collections department. receivables management, and collection of a large number Alternatively, the firm could factor the receivables at an of smaller invoices will consume more resources on the annual cost of $200,000, eliminate credit write-offs, and part of the factor, and this will be reflected in its fees. avoid expanding the credit/collections department. XYZ’s The longevity of the factor-company relationship annual cost of factoring of $200,000 compares favorably affects both the cost of factoring as well as the advance to the annual cost of $275,000 for traditional lending. rates. As the partnership matures, the company will likely Obviously, factoring may not cost less than traditional see front-end discount fees decline and advance rates lending in all circumstances, but it isn’t necessarily cost increase. This reflects a natural progression of the rela- prohibitive either. tionship as the factor better understands the company With a large, professional factor, the dilution rate and its operations. Also, the company needs to evaluate (uncollectible accounts rate) may actually improve as a the factor and assess its ability to provide needed services. result of the management services the factor provides. Accounts receivable turnover, the velocity at which Many companies, especially small firms, can’t devote the receivables are collected, is also directly related to the cost resources necessary for adequate receivables manage- of factoring.
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