Factoring
Factoring is a form of accounts receivable financing. However, instead of borrowing and using receivables as collateral, the receivables are sold, at a discounted value, to a person or firm called a factor. Factoring is accomplished on a discounted value of the receivables pledged. Invoices that do not meet the factor's credit standard will not be accepted as collateral. (Receivables more than 90 days old are not normally accepted.) A bank may inform the purchaser of goods that the account has been assigned to the bank, and payments are made directly to the bank, which credits them to the borrower's account. This is called a notification plan. Alternatively, the borrower may collect the accounts as usual and pay off the bank loan; this is a nonnotification plan.
Factoring can make it possible for a company to secure a loan that it might not otherwise get. The loan can be increased as sales and receivables grow. However, factoring can be expensive, and trade creditors sometimes regard factoring as evidence of a company in financial difficulty, except in certain industries.
In a standard factoring arrangement, the factor buys the client's receivables outright, without recourse, as soon as the client creates them by shipment of goods to customers. Although the factor has recourse to the borrowers for returns, errors in pricing, and so on, the factor assumes the risk of bad debt losses that develop from receivables it approves and purchases. Many factors, however, provide factoring only on a recourse basis.
Cash is made available to the client as soon as proof is provided (old-line factoring) or on the average due date of the invoices (maturity factoring). With maturity factoring, the company can often obtain a loan of about 90 percent of the money a factor has agreed to pay on a maturity date. Most factoring arrangements are for one year.
Factoring can also be on a recourse basis. In this circumstance, the borrower must replace unpaid receivables after 90 days with new current receivables to allow the borrowings to remain at the same level. If you are growing, replacing receivables is usually not a problem.
Factoring fits some businesses better than others. For a business that has annual sales volume in excess of $300,000 and a net worth over $50,000 that sells on normal credit terms to a customer base that is 75 percent credit rated, factoring is a real option. Factoring has become almost traditional in such industries as textiles, furniture manufacturing, clothing manufacturing, toys, shoes, and plastics.
The same data required from a business for a receivable loan from a bank is required by a factor. Because a factor is buying receivables with no recourse, it will carefully analyze the quality and value of a prospective client's receivables. It will want a detailed aging of receivables plus historical data on bad debts, returns, and allowances. It will also investigate the credit history of customers to whom its client sells and establish credit limits for each customer. The business client can receive factoring of customer receivables only up to the limits so set.
The cost of financing receivables through factoring is higher than that of borrowing from a bank or a finance company. The factor is assuming the credit risk, doing credit investigations and collections, and advancing funds. A factor generally charges up to 2 percent of the total sales factored as a service charge. There is also an interest charge for money advanced to a business, usually 2-6 percent above prime. A larger, established business borrowing great sums would command a better interest rate than the small borrower with a one-time, short-term need. Finally, factors withhold a reserve of 5-10 percent of the receivables purchased.
Factoring is not the cheapest way to obtain capital, but it does quickly turn receivables into cash. For a growth-oriented company, factors can provide valuable fuel. Moreover, although more expensive than accounts receivable financing, factoring saves its users credit agency fees, salaries of credit and collection personnel, and maybe bad debt write-offs. Factoring also provides credit information on collection services that may be better than the borrower's as they approve credit from many suppliers.
Leasing Companies
The leasing industry has grown substantially in recent years, and lease financing has become an important source of medium-term financing for businesses. There are about 700 to 800 leasing companies in the United States. In addition, many commercial banks and finance companies have leasing departments. Some leasing companies handle a wide variety of equipment, while others specialize in certain types of equipment - machine tools, electronic test equipment, and the like.
Common and readily resalable items such as automobiles and trucks and office furniture can be leased by both new and existing businesses. Generally, industrial equipment leases have a term of three to five years, but in some cases may run longer. There can also be lease renewal options for 3-5 percent per year of the original equipment value. Leases are usually structured to return the entire cost of the leased equipment plus finance charges to the lessor, although some so-called operating leases do not, over their term, produce revenues equal to or greater than the price of the leased equipment. Typically, an up-front payment is required of about 10 percent of the value of the item being leased. The interest rate on equipment leasing may be more or less than other forms of financing, depending on the equipment leased, the credit of the lessee, and the time of year.
Leasing credit criteria are very similar to those used by commercial banks for equipment loans. Primary considerations are the value of the equipment leased, the justification of the lease, and the lessee's projected cash flow over the lease term.
Should a business lease equipment? Leasing has certain advantages. It enables a young or growing company to conserve cash, and can reduce its requirements for equity capital. Leasing can also be a tax advantage, because payments can be deducted over a shorter period than depreciation.
Finally, leasing provides the flexibility of returning equipment after the lease period if it is no longer needed or if it has become technologically obsolete. This can be a particular advantage to companies in high-technology industries.
Leasing may or may not improve a company's balance sheet, because accounting practice currently requires that the value of the equipment acquired in a capital lease be reflected there. Operating leases, however, do not appear on the balance sheet. Generally speaking, this is an issue of economic rather than legal ownership. If the economic risk is primarily with the lessee, it must be capitalized and therefore goes on the balance sheet along with the corresponding debt. Depreciation also follows the risk, along with the corresponding tax benefits. It should be noted that start-ups that don't need such tax relief should be able to acquire more favorable terms with an operating lease.
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