One of the primary characteristics of factoring and what differentiates this unique method of business finance from traditional bank financing is that it is never structured as a typical loan, but is rather a purchase and sale form of finance. Though invoices (accounts receivable) can be the collateral for both factoring and traditional lending, factors actually purchase the invoices (and rights to collection) rather than lending against them. With traditional bank loans, the business owner is the responsible party for making loan payments whereas with factoring, the account debtors (customers) of a business are responsible for payment on their invoices. Factors will, therefore, track the cycle of each invoice from creation to payment, since the repayment of the factor’s advance depends primarily on eventual and timely payment by the customer.
Though likely still a little new, grasping the basic concept of factoring is actually relatively simple and from a very normal transaction standpoint, any factoring transaction can be broken down into three (3) distinct processes which are …
- The Advance of Funds
- The Collection of Funds
- The Reserve Distributions or Rebates to the Client
The Advance of Funds
All factoring transactions begin with an advance of funds upon invoices submitted by the factoring client. Submissions are typically made weekly but clients, and their businesses, can differ significantly and some will submit invoices as often as daily while others bi-weekly or even monthly will suffice. Once the invoices are verified, a batch or list is created which details each invoice approved to be initially advanced upon.
When contracting with a new client, the factor will determine an initial advance rate which is the percentage rate of the face value upon invoices in the advance it purchases. Throughout the industry, the most common rate of advance is 80% to 85%, but on occasion, factors will advance 90% or even higher. This higher advance rate can occur in situations where the account debtors are exceptionally strong, creditworthy payers and the payment for goods sold or service performed has very little chance of being reduced with credit memos, spoilage, chargebacks, etc.
Initial advance percentage rates can also vary markedly depending on the client’s industry. For example in the construction industry, where a 10% payment holdback is common and is known as retainage, the advance rates on purchased invoices might be 70% instead of the more common 80% to 85%. This is to protect the factor from shortfalls caused by the 10% retainage holdback.
Advance rates on invoiced sales where the invoice amounts are very small may also be subject to slightly lower advance rates simply due to the overall increase in expense to the factor in processing such small transactions. Contrarily, clients who present large invoices for purchase with very strong, creditworthy customers are often provided with both higher advance rates and lower factoring fees.
The Collections Process
All factors will become involved in the collection and payment process upon purchased invoices and will typically have in-house personnel assigned to that task. For the most part, collections tend to take care of themselves with account debtors remitting payment within their payment terms.
Each month, factors will generate monthly statements of account which will be mailed to all account debtors of all clients. The statements of account will list all invoices outstanding and will be directed to the customer’s accounts payable department. Courteous collection calls will be made by the factor’s collection staff to check up on those payments which have not been received by their normal due date.
As a broker or consultant, I should understand that some prospective new factoring clients may be concerned about the factor’s staff contacting their customers and being too harsh in collections. In reality, there is really no need for worry since the factor’s collection staff are highly trained professionals who are well aware of the relationship between client and customer. They are also aware that mistreating customers can lead to a client leaving a particular factor to seek another.
Rebates and the Factor’s Reserve
The percentage of the face value of the invoice not initially advanced is referred to as the factor’s reserve. An initial advance rate of 80%, for example, means the client will receive a wire or ACH of cash for 80% of the invoice face amounts directly in the business checking account. The 20% balance not advanced remains “on the books” as reserve or more specifically, uncollected reserve.
Uncollected reserve is simply a bookkeeping entry and represents an anticipated amount of additional cash to be available when the purchased invoice is paid by the customer (account debtor). Once a payment is actually received, uncollected reserve, the bookkeeping entry, becomes cash reserve and such additional cash, less the factor’s service fee, is then available to be paid to the client through what is termed a reserve distribution, or as it is more commonly termed, a rebate.
The availability for reserve rebates or distributions actually depends on a variety of circumstances. For example, does the client have some additional invoices which are aged over 90 days and in jeopardy of being charged-back or are there invoices not being paid due to a trade dispute? Are there unforeseen expenses, such as legal or tax expenses, which must be paid by the factor for the client’s benefit? If so, cash reserve generated from one invoice or a group of invoices may be temporarily held to address unforeseen expenses and to guarantee the factor’s repayment for the advance on the disputed invoice(s) or to pay certain required legal expenses.
The amount of uncollected reserve scheduled for rebate will also be reduced by the earned factoring fees before it can distributed. Once a payment is received from a customer on an invoice, that check payment and detail information will be entered into the factor’s invoice tracking software and credited to the appropriate invoice. Factoring fees will be tallied and deducted, a collection report will be generated, and if there are no other circumstances which would prevent it, a reserve distribution, or rebate, is then readied to be made to the client.
