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 they collect the invoice, the lender pays the remaining 20% (less a fee) 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. They will also obtain information on the company’s customers.

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, lenders require a pre-funding audit of the prospective borrower.

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 that needs to be factored. It will have 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%.

Discount Fee

Hold the amount not advanced to the borrower in reserve. Then as customers pay the invoices, release the amount held in reserve to the borrower, less a discount fee.

The discount fee is a percentage determined by a fee schedule. The factoring proposal lays out the fee schedule. The fee is a function of the time it takes for the customer to pay the invoice plus a variable component. The variable component is based upon the prime lending rate. The less time it takes to collect, the smaller the fee. Apply the discount fee to the amount of funds advanced to the borrower.

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

Factoring Lender Reports…..What They Give You

Purchases & Advances Report

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.

Collections Report

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 the following:

  • Invoice number
  • Invoice amount
  • Date payment received
  • 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.

Reserve Report

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. This is 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.

If you want more ways to add value to your company, then download your free A/R Checklist to see how simple changes in your A/R process can free up a significant amount of cash.

factoring receivables

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