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What is Factoring Receivables

See Also:
Another Way To Look At Factoring
Accounting for Factored Receivables
Journal Entries for Factored Receivables
Can Factoring Be Better Than a Bank Loan?
History of Factoring
How Factoring Can Make or Save Money
Factoring is Not for My Company
The What, When, and Where About Factoring

What Is Factoring Receivables?

Factoring receivables is the sale of accounts receivable for working capital purposes. A company will receive an initial advance, usually around 80% of the amount of an invoice when the invoice is purchased by the lender. When the invoice is collected, the remaining 20% (less a fee) will be paid to the borrower.

There are two types of factoring conditions: 1) Factoring With Recourse and 2) Factoring Without Recourse. The term recourse refers to whether or not the shareholder(s) of the company are personally liable for the factored receivables in case the company’s client(s) don’t payback the invoiced amount. By far most factoring relationships are conditioned upon With Recourse terms. By shifting more of the risk onto the shareholder(s) of the company, the factoring lender is able to then charge lower fees.

Qualifying for Factoring

The first step in receiving factoring financing is to be pre-qualified by a factoring company or a bank’s factoring department. Typically this will entail an in-person meeting to review why the company is in need of factoring, as well as the provision of a company’s financial statements and supporting schedules (such as receivables and payables aging schedules) to document its operating history. Information on the company’s customers will also be obtained.

A proposal for a factoring relationship will be created. This document will outline the proposed terms of the financing, including a facility limit, advance rate, discount fee schedule, repurchase provision, other fees, liens, process for notification of assignment, confirmation of receivables, and reporting requirements.

The proposal will be negotiated between the company and the representative(s) of the lender before being submitted to the loan committee of the lender for approval. Typically for proposed credit facilities of $1 million or more, a pre-funding audit of the prospective borrower will be required.

Factoring Operations

In a factoring relationship, all payments collected for accounts receivable are to be sent to the lender, typically to a “lock-box” under their control. Customers are to be notified of this by a Notification of Assignment letter which will also contain the new payment instructions. Invoices sent by the borrower to their customers will be required to contain the new payment instructions as well.

The borrower decides what invoices to factor (“sell”) by notifying the lender, through the use of a document typically known as a “Schedule A” form. This document will list each individual invoice to be factored, with details such as the customer name, invoice number, date, amount, and corresponding purchase order or reference number of the customer. The Schedule A is to be accompanied by documentation which substantiates that the goods or services have been provided to the customers. The lender will decide which invoices it will purchase and then will advance funds to the borrower. This advance is based upon an agreed upon advance rate. The rate is typically around 80%.

The amount not advanced to the borrower is held in reserve. As invoices are paid by customers, the amount held in reserve is released to the borrower, less a discount fee.

The discount fee is a percentage determined by a fee schedule which is laid out in the factoring proposal. The fee is a function of the time it takes for the invoice to be paid plus a variable component which is based upon the prime lending rate. The less time it takes to collect, the smaller the fee. The discount fee is applied to the amount of funds advanced to the borrower.

For those invoices which are not collected within 90 days of the invoice date, a repurchase provision will apply which requires the borrower to buy back the invoice, along with a late payment fee (around 5%).

Factoring Lender Reports…..What they give you

The lender will provide a Purchases & Advances Report, which identifies the invoices purchased by the lender, along with the advance rate and amount of each invoice advanced to the borrower. This is typically available daily online.

Lenders also provide a Collections Report, which lists all payments received from a borrower’s customers. Remember that the lender will receive and process all payments for a borrower’s receivables. There are two formats for a Collections Report. Format A lists all payments received for a borrower’s receivables and identifies those which apply to non-factored invoices as well as factored invoices. The detail on a Format A report will include, by invoice number, the invoice amount, the date payment was received and the amount of the payment collected for each invoice. The second format of a Collections Report is Format D. On a Format D report, information about the reserve refund and discount fee paid out of the reserve for a given invoice is also provided.

The Reserve Report provided by a lender details changes in the borrower’s reserve account. As invoices are paid and processed, the factoring lender will remit the remaining portion of the reserve, usually 20% of the leftover invoice, net of fees. Should there be any outstanding invoices that a customer has not paid back within the agreed upon time period, the factoring lender may require the company to buyback that invoice AND still charge a fee. This type of situation is called “with recourse” because the lender can force the company to “buy back”: delinquent invoices.

The borrower is usually required to provide monthly financial statements, including A/R and A/P aging schedules, within 30 days of a month’s end.

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What Is Dilution

See Also:
Financial Ratios
Accounts Receivable Turnover
How to collect accounts receivable
What is Factoring Receivables?
Working Capital

What is Dilution?

Dilution is any portion, regardless of why, of your receivables that you did not collect. This is important as the amount available from your line of credit with the bank is based on your outstanding accounts receivable balance. The bank wants to know the extent to which your receivables are likely to be turned into cash receipts. The greater the amount of dilution, the greater the risk to the bank and the less will be your available borrowing base.

The following are common causes of dilution and suggestions for remedying them.

Discounts

Discounts offered to customers for faster repayment can increase your dilution rate. If these discounts account for a significant amount of dilution, you may consider other methods of encouraging faster repayment.

Collection costs

The greater the fees directly paid to collect on your receivables, the less of your receivables balance you will realize. This is worth examining to see if it has a material impact on your dilution rate. You may consider less costly collection services.

Bad debt

Receivables not collected due to the default or other negligence of the customer. This can be reduced through the establishment of tighter credit policies, such as more thorough credit checks prior to extending trade credit to customers.

Offsets

Sometimes a customer may also be a vendor. In the course of paying an invoice it may seem attractive to you or them to net out the amount they owe you from the invoice’s total. You may want to end this practice depending on the amount of the dilution and its subsequent impact on your borrowing base availability.

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Working Capital Analysis

See Also:
Balance Sheet
How to collect accounts receivable
Factoring
Working Capital from Real Estate
Quick Ratio Analysis
Current Ratio Analysis
Financial Ratios

Working Capital Definition

Working capital, also known as net working capital, indicates the total amount of liquid assets a company has available to run its business. In general, the more working capital, the less financial difficulties a company has.

Working Capital Formula

Working capital = Current assetsCurrent liabilities

Working Capital Calculation

Example: a company has $10,000 in current assets and $8,000 in current liabilities.

Working capital = 10,000 – 8,000 = 2,000

Applications

Working capital measures a company’s operation efficiency and short-term financial health. Positive working capital shows that a company has enough funds to meet its short-term liabilities. Negative working capital shows that a company has trouble in meeting its short-term liabilities with its current assets.

Working capital provides very important information about the financial condition of a company for both investors and managements. For investors, it helps them gauge the ability for a company to get through difficult financial periods. For management members, it helps them foresee any financial difficulties that may arise. It is very important for a company to keep enough working capital to handle any unpredictable difficulties.

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Operating Capital Definition

Operating Capital Definition

Operating capital is defined as the cash used for daily operations in a company. As a result, it is essential to the survival of each and every business. Whether small or large, across industries, and under any other conditions that a business faces, lack of cash is one of the main reasons why a company fails. Due to this fact, it is of key importance that businesses monitor and plan for future cash holdings to assure that the business will have the money needed to continue doing commerce.

(NOTE: Want the 25 Ways To Improve Cash Flow? It gives you tips that you can take to manage and improve your company’s cash flow in 24 hours!. Get it here!)

Operating Capital Explanation

Operating capital, explained as the most essential asset in any business, allows a company to stay open. Also known as working capital, it can come from many sources. Operating capital vs working capital is a similar comparison to red vs maroon apples: there is no difference.

The initial operating capital for small business will come from investors. This could come in the form of savings of the owners, friends and family of the owners, banks and the S.B.A., angel investors, or venture capital.

For an existing business, operating capital outlay will come from more providers than for the startup. The same options exist with current owners, friends and family, banks and the S.B.A., and more. Additionally, however, a business can receive operating capital loans from mezzanine financiers, factoring, or becoming a public company and selling stock on the open market.

Operating Capital Formula

Though the operating capital formula is a simple function of subtraction it is actually quite complicated. The difficult part of operating capital requirements is the research associated with finding current asset and current liability amounts. Once these questions are answered the operating capital ratio comes naturally.

Operating Capital = Current Assets – Current Liabilities

Operating Capital Calculation

The operating capital calculation is quite simple.

If:

Current Assets = $1,000,000

Current Liabilities = $250,000

Operating Capital = $1,000,000 – $250,000 = $750,000

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Operating Capital Example

Chris is the CFO of a large company – a series of retail stores which sell plants for home decor. Chris plans the company finances to assure smooth operations. This includes managing company operating capital.

Recently, the company has experienced enormous growth. While this is a great signal that the business model is sound, it can also form a operating capital crisis. Consequently, Chris must move forward carefully to avoid financial ruin for the company.

First, Chris wants to know where the company stands. He then performs this working capital calculation to see where the business is currently:

Current Assets = $1,000,000

Current Liabilities = $250,000

Operating Capital = $1,000,000 – $250,000 = $750,000

Chris knows that $750,000 is not enough money to get the company through this quarter. He also knows that with insufficient working capital the company will have to seek financing from a lender who is less risk averse. So Chris does his research.

The two choices Chris learns are possible are factoring and mezzanine lending. Therefore, Chris will need to do a lot of research to evaluate both options. As he does this research, he is empowered by the importance of his work: the fate of the company rests upon it.

In conclusion, Chris chooses mezzanine lending as the option for the company. With mezzanine lending, he can have a total cost of capital lower than that with factoring. Additionally, mezzanine lenders will offer more money that that in the value of the receivables of the company.

Chris moves forward carefully in order to avoid a mistake. Because his nature as a planner makes this path an easy one, Chris will wait until he is prepared and then make the proper decision.

For more ways to improve your cash flow, download the free 25 Ways to Improve Cash Flow whitepaper.

Operating capital

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Operating capital

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Collect Accounts receivable

See Also:
Accounts Receivable Collection Letter
Financial Ratios
Accounts Receivable Turnover
What is Factoring Receivables?
Net 30 Credit Terms
Accounts Receivable Collection Letter

Collect Accounts Receivable

Every company has them…past due and slow pay accounts. Here are some ways to help keep your cash coming in the door and collect accounts receivables.

Improve Accounts Receivable Collection and Invoicing

Commercial and industrial experience has proven the following percentages: Of ten new customers, six will pay on time, two will pay in 60 to 90 days and two will become collection problems.

Always watch your new sales. As money becomes tighter, you will receive one-time sales from firms that may be experiencing financial problems. These customers will bounce from business to business and need your close attention. A useful management tool for collecting accounts receivable is the Flash Report.

Be familiar with your customers’ credit. Only extend credit to organizations you feel confident will pay you. Make sure you don’t have to write off your hard earned sales through bad debt!

Pay close attention to the credit terms you are offering your customers. One good way to collect accounts receivable (ar) is to do so before you deliver your product and structure your terms accordingly. An example of this would be a propane company in the winter months; nothing works better than to be paid prior to delivery.

Examples of accounts receivable payment terms:

For custom manufacturing companies:

50% before work begins, 40% before delivery and 10% after delivery

For wholesalers and retailers:

Depending on creditworthiness, 10 days net for companies with good credit, prior to delivery for companies with questionable credit or those that are past due.

Develop a minimum sales order that will require a credit check

Check three references on a new client

If payment history is greater than 60 days obtain supervisor approval

The following steps should be preformed in invoicing the customer:
– invoice within 24 to 48 hours after performing service
– review invoices for accuracy
– make sure that everything has been billed
– note payment terms on the invoice

Assign Responsibility for Accounts Receivable Collections

Use a dedicated collections individual. Designate one person in your organization to be the accounts receivable collections representative, someone who can make the collection calls and stay on top of accounts receivable. There are some personality traits that you should look for when assigning this function. Some traits to look for: A professional presence, adept at working with and handling difficult people, skilled at follow up and well organized in order to document collection efforts.

You may want to pay your accounts receivable collections individual a commission as an incentive to keep accounts receivable collections current. Alternatively, you might consider paying a bonus at certain increments based on established criteria.

The goal is to work with delinquent companies and receive payment as quickly and cost effectively as possible!

For many companies, accounts receivable collections may not be a full time commitment and may be added to a current employee’s responsibilities. If there is a legitimate reason the customer has not paid, it’s best to get this taken care of early so as not to impact your cash flow for any longer than necessary. Never underestimate the impact of reminder and collection calls!

Accounts Receivable (AR) Collection by Telephone

Given the use of voice mail the effectiveness of phone calls are somewhat diminished. However, they are still an effective means of collection. The phone calls enable the credit manager to present their case to the debtor for immediate response. During the conversation you can determine whether the claim will be paid in full and when. This is the time to determine the reasons for non-payment.

Three main reasons for non-payment
– Lack of funds. Most non-payments result from lack of funds.
– Dispute. Disputes can be discussed to determine whether or not they are valid. The valid claim must be adjusted quickly and fairly, the non-valid claim exposed and immediate payment requested.
– Refusal to pay. If it is refusal to pay, you must take third-party steps to enforce payment. Consider hiring a collections attorney.

Tips on phone collections
– Identify yourself and the company
– Call the person in charge
– Ask for the payment in full by a specific date
– If the bill is in dispute, suggest a solution
– If a solution is met, put it in writing
– If a solution is not met, set up a personal meeting with the client

Managing the Accounts Receivable Process

To quote Peter Drucker: You can’t manage it if you don’t measure it! The same holds true for collecting accounts receivable! So how do you measure your effectiveness in collecting accounts receivable?

Daily Sales Outstanding (DSO)

What is DSO? DSO is the average of your accounts receivable. The numerical accuracy of the number is not as important as the trend. It is intended to be a blended estimate of how long it takes to collect your accounts receivable. If you are making progress then it should be trending lower. The first thing you should do is calculate where you are today.

How do you calculate DSO?

DSO = 365/ (Annual Credit Sales/ Average Accounts Receivable)

Commercial Collection Servicies

Hire a collection agency. Ways to find a reputable collection agency include referrals from other companies as well as professional firms and organizations with which your company does business. No matter how you receive the referral, be sure to ask the collection agency for customer references and call the references. Some questions to ask: How responsive is the collection agency to your questions? Do they report progress on your accounts promptly and in a format that is user friendly? Do they remit proceeds quickly and accurately? Do they resolve issues quickly?

Final Comments

Review your internal processes. Collecting accounts receivable is an internal process as well! Before initiating collection calls, be sure your internal house is in order. It is vitally important that your cash applications are timely and done correctly. It’s extremely embarrassing and inefficient to have your collections representative make a collection call only to find that the customer has in fact paid the bill and the payment has been misapplied. A similar situation exists when a collection call is made and the payment was received 2 weeks earlier.

AR Collections should start with your cash applications function. Your process here is critical and must be followed without exception. Payments must be applied quickly and accurately. If a payment cannot be identified to an invoice, the customer MUST receive a timely phone call to identify what is being paid.

Make sure you issue invoices that make cash application quick and easy. Automation can be a big help when there are large volumes of invoices or you are short staffed. All systems should have an organized and mechanical follow up of accounts at regular intervals, for instance, 10,30 and 60 days past due.

Any program that permits three statements or a two to three month time lag before the first collection step is taken will result in a lower recovery ratio. Make collections update meetings a priority for the controller and collections person. At the meeting, collection notes, progress and next steps should be reviewed.

Know the cost of past due accounts. If you cover your cash shortfalls with a line of credit, consider that at an interest rate of 10% on your line, every $100,000 in past due accounts costs you $833 per month or $10,000 per year.

Train your customers to be good payers. Creating an accounts receivable collection process and following it consistently will allow you to accomplish this important goal.

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Days Payable Outstanding

See Also:
Accounts Payable
Accounts Payable Turnover
Days Sales Outstanding (DSO)
Days Inventory Outstanding (DIO)
How to Create Dynamic Cash Flow Projections

Days Payable Outstanding Definition

Days payable outstanding (DPO), defined also as days purchase outstanding, indicates how many days on average a company pay off its accounts payables during an accounting period. A useful tool to measure and manage DPO is a Flash Report.

Days Payable Outstanding Meaning

Days payable outstanding means the activity ratio that measures how well a business is managing its accounts payable. The lower the ratio, the quicker the business pays its liabilities. It also shows the average payment terms granted to a company by its suppliers. The higher the ratio, the better credit terms a company gets from its suppliers. From a company’s prospective, an increase in DPO is an improvement and a decrease is deterioration.

Days Payable Outstanding Formula

The days payable outstanding formula is listed in two forms below:

Days payable outstanding = (average accounts payable / cost of goods sold) * 365 days

Or

Days payable outstanding = average accounts payable / (cost of sales / 365 days)

(NOTE: Want the 25 Ways To Improve Cash Flow? It gives you tips that you can take to manage and improve your company’s cash flow in 24 hours!. Get it here!)

Days Payable Outstanding Calculation

Days payable outstanding calculations can occur in the following method:

Example: a business has $ 2,500 in accounts payable, $ 12,500 in cost of goods sold.
Days payable outstanding = (2,500 / 12,500) * 365 = 73 days

Days Payable Outstanding Example

Leslie has a business which provides raw materials, from her distributors, to product manufacturers. Her business, reliant on relationships with customers, offers trade credit on the materials she sells.

Leslie wants to make sure her business is being paid on time with her competitors. This gives her the expectable cash cycles required to maintain a competitive edge. Simply, Leslie wants to know her days payable outstanding. She first asks the question “what is days payable outstanding?”

Leslie contacts her CFO and requests the answer to her question. Recently, she has become aware of the importance of financial ratios in commerce. Though Leslie is not an accountant she wants to make sure that she is in control of the success of her business, and sees an understanding of her financials as one of the many aspects to this.

Leslie’s CFO performs this days payable outstanding analysis:

$2,500 in accounts payable and $12,500 in cost of goods sold.
Days payable outstanding = (2,500 / 12,500) * 365 = 73 days

Now it is time for Leslie, as the CEO of her company, to step into action. She finds an expert in the industry and discovers that 37 days is a good days payable outstanding benchmark. She is pleased with these results.

Leslie can now move on to other tasks in her company. She is confident that with her analytical mind and the help of her qualified CFO growth can occur. For more ways to improve your cash flow, download the free 25 Ways to Improve Cash Flow whitepaper.

days payable outstanding

Strategic CFO Lab Member Extra

Access your Cash Flow Tuneup Execution Plan in SCFO Lab. This tool enables you to quantify the cash unlocked in your company.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

days payable outstanding

Resources

For statistics information about industry financial ratios, please go to the following websites: www.bizstats.com and www.valueline.com.

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Accounts Receivable Turnover Example

See Also:
Accounts Receivable Turnover Analysis

Accounts Receivable Turnover Formula Example

To emphasize it’s importance we will provide an accounts receivable turnover ratio example. Many companies live and die by collections. These rates are essential to having the necessary cash to cover expenses like inventory, payroll, warehousing, distribution, and more.

Manufactco is a company that manufactures widgets. Manufactco’s widgets have become very popular. The company is growing quickly and must hire new employees for their plant.

Annual Credit Sales: $10,000 Accounts Receivable in 1/1/09: $2,500 Accounts Receivable in 12/31/09: $1,500

Currently, Manufactco’s accounts receivable turnover rate is:

$10,000/ (($2,500 + $1,500)/2) = 5 times

Every company should have someone tasked as, amongst other bookkeeping matters, head accounts receivable turnover calculator. This person is known as a Chief Financial Officer (CFO). She has found that a full turnover happens 5 times in one year. To rephrase, in a full year all open accounts receivable are collected and closed 5 times. This is the accounts receivable turnover ratio meaning.

Now let’s make things a bit more complicated. How many accounts receivable turnover days will it take to complete one cycle?

Simply use this formula: Days Receivable Outstanding = # of days / accounts receivable ratio calculation

Many companies Google “accounts receivable turnover ratio calculator”, look towards their BA II, or scour their local bookstore. A properly trained CFO, however, has the answers to this and many other questions.

The period for this example begins at 1/1/09 and ends at 12/31/09. The number of days for this period, then, would be 365. Manufactco’s accounts receivable equation for the number of days a receivable is outstanding is:

365 days / 5 times = 73 days for AR to turnover

This means that all open accounts receivable are collected and closed every 73 days. In 73 days customers make a purchase, are reminded that payment is due, send payment, have payments processed, and have receivable accounts closed.

The Chief Financial Officer of Manufactco now knows that 5 full turnovers happen in a year. She also knows that it takes 73 days for one full turnover to occur. Creating a profitable company is now a simple matter.

Tightening credit policies is one common method. Options include decreasing the amount of days allotted before payment is due, including or increasing discounts for early payment, or increasing the late payment penalty fee. Additionally, she could update collections technologies or simply increase collections staff. In extreme conditions Manufactco could even stop serving certain customers, in effect “firing” those who are late or non-paying. All of these tools are available for the clever CFO.

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