Feed: Require Financing Right Now? Look At Factoring Receivables - AggScore: 14.0

Require Financing Right Now? Look At Factoring Receivables

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Factoring receivables is a type of transaction where a business firm sells its debtors, also known as accounts receivables, at a discount to a accounts receivable factoring firm for immediate payment. The key benefit for the business firm is that it will be paid the agreed cash price up-front as soon as the transaction is agreed upon, boosting its cash flow. A second benefit is that the business firm will no longer be concerned by debtor default risk.

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 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 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.

In effect, the factoring firm has traded a risk-free profit of $45 for a risky profit of $200. Allowing for this time cost of money, the net profit earned by the factoring firm is ($200 - $45) = $155 per month. This is the amount by which the firm is being rewarded for incurring the risk of debtor default. It translates to $155 / $9,000 = 1.72% per month or 22.7% per annum.

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 wanting to sell their receivables will be asked by the factoring firm to submit profile information about itself and its customers. The objective of the asset based loan firm is to assess the credit standing of the customers of the business. The profile information will cover the name and address of the business, its activities and, most importantly, its aged receivables report. If at all possible, the firm will rate the credit standing of the customers as stand alone entities independent of their credit performance with the business.