Require Money Right Now? Think About Factoring Receivables
pFactoring 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 a href=http://hubpages.com/hub/factoring-receivablesinvoice factoring/a 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./p
pAs an example, take a firm with debtors totaling $10,000 book value with an aged profile of 30 days (time weighted average). A factoring firm offers to purchase the debtors for $9,000. The firm accepts the offer and the debtors are legally transferred to the factoring firm. It then becomes responsible for their collection./p
pIn 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./p
pHaving 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)./p
pThe time cost of money refers to the risk-free opportunity cost incurred by the factoring firm. As a result of investing $9,000 to purchase the accounts receivables, the factoring firm has foregone the opportunity to invest that $9,000 in a short term money market account based on risk-free government securities at an interest rate of, say, 0.5% per month (6.2% per annum). Accordingly, by purchasing the receivables from the commercial business, the factoring firm has foregone the opportunity to earn $45 per month risk-free./p
pThe 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 a href=http://www.greenfieldcredit.com/products/asset-based-lending/asset based loan/a 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./p
pTo be clear, to earn this incremental 22.7% per annum profit, the factoring firm had to carry the risk of generating an infinite range of outcomes, including losses. For example, if the debtor default rate had of been 12% instead of 8%, then the factoring firm would have collected only $8,800 at the end of the month and incurred a total loss of $200 instead of earning a worry-free return of $45./p
pBusinesses 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 a href=http://www.greenfieldcredit.com/products/factoring/invoice factoring/a 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 factoring receivables firm will rate the credit standing of the customers as stand alone entities independent of their credit performance with the business./p
