Accounts receivable can be pledged to a lender as security against a loan. Instead of pledging receivables, however, a firm may engage in factoring receivables to acquire cash. In pledging accounts receivable, the firm still retains title to the receivables. When a firm factors its receivables, it transfers title to the receivables by actually selling them to a factor (often a subsidiary of a bank holding company). The sale is usually â€œwithout recourse,â€? meaning that the selling firm would not be liable for any receivables not collected by the factor.
The factor maintains a credit department and makes credit checks on accounts. Based on its credit investigation, the factor may refuse to buy certain accounts that it deems too risky. By factoring, a firm frequently relieves itself of the expense of maintaining a credit department and making collections. Thus, factoring can serve as a vehicle for outsourcing credit and collection responsibilities. Any account that the factor is unwilling to buy is an unacceptable credit risk unless, of course, the firm wants to assume this risk on its own and ship the goods.
Factoring arrangements are governed by a contract between the factor and the client. The contract is frequently for one year with an automatic provision for renewal and can be cancelled only with prior notice of 30 to 60 days. Although it is customary in a factoring arrangement to notify customers that their accounts have been sold and that payments on the account should be sent directly to the factor, in many instances notification is not made.
Customers continue to remit payments to the firm, which, in turn, endorses them to the factor. These endorsements are frequently camouflaged to prevent customers from learning that their accounts have been sold.
Factoring may seem to be a rather foreign concept. You may, therefore, be surprised to learn that you have probably been a party to numerous factoring transactions without even realizing it. Every time that you make a purchase using a bank credit card you are involved in a factoring arrangement. The account receivable created by your credit purchase is being sold to a bank.
For bearing credit risk and servicing the receivables, the factor receives a commission, which for trade accounts is typically somewhat less than 1% of the face value of the receivables. The commission varies according to the size of the individual accounts, the volume of receivables sold, and the quality of the accounts. The factor generally does not pay the firm immediately on the purchase of accounts receivables. Rather, cash payment is usually made on the actual or average due date of the accounts receivable involved. If the factor advances money before it is due from customers, the firm must pay the factor interest on the advance. Advancing payment is a lending function of the factor in addition to risk bearing and servicing the receivables. For this additional function, the factor requires compensation. If the factored receivables total $10,000 and the factoring fee is 2%, the factor will credit the firmâ€™s account with $9,800. If the firm wants to draw on this account before the receivables become due, it will have to pay an interest charge — say, 1.5% a month, — for the use of funds. If it wishes a cash advance and the receivables are due, on the average, in one month, the interest cost will be approximately 0.015 x $9,800 = $147. Thus, the total cost of factoring is composed of a factoring fee plus an interest charge if the firm takes a cash advance. If the firm does not take a cash advance, there is no interest charge. In a third alternative, the firm may leave its funds with the factor beyond the receivablesâ€™ due date and receive interest on the account from the factor.