Factoring Receivables - A Closer Look

Factoring receivables is a type of transaction where a business firm sells its debtors, also known as accounts receivables, at a discount to a factoring firm for immediate payment. The key benefit for the business firm is that it will be paid the agreed cash price up-front as soon as the transaction is agreed upon, boosting its cash flow. A second benefit is that the business firm will no longer be concerned by debtor default risk.

As 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.

The $1,000 gap between the $10,000 book value and $9,000 paid for that value is the discount accepted by the firm for its debtor asset. This discount covers the non-payment (default) risk by debtors, the time value of the $9,000 for the 30 day credit period and a profit for factor firm.

Having 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).

The time value of money is an opportunity cost for the factor firm since it foregoes the opportunity of earning a risk-free return on the $9,000 it used to acquire the debtors. By using those funds to invest in debtors, the factor firm cannot invest that $9,000 in the risk-free money market deposit. If the interest rate paid on that money market deposit is 0.5 percent each month (or 6.2 percent each year), the factor firm loses a worry-free monthly interest return totaling $45.

The factor firm has, in effect, swapped a risk-free $45 profit for a risky outcome that may even be a loss. As it happens, in the above example, this risky outcome turns out to be a $200 profit. By not accepting a risk-free $45 the factoring firm earns an incremental $200 - $45 = $155 profit. This incremental profit represents the reward for carrying the risk of default by debtors. It translates to $155 / $9,000 = 1.72 percent monthly or 22.7 percent yearly.

To generate this incremental 22.7 percent yearly return, the factor firm has to carry the risk (accept the possibility) of an infinite outcomes, including possible losses. For example, if the debtor default rate had of been, say, 12 percent rather than 8 percent, then the factoring firm would collect only $8,800 during the credit period and suffer a loss of $200 instead of a worry-free profit of $45.

Any business attempting to factor or sell their receivables will be required by the factor firm to submit detailed information about itself and its customers or debtors. The factoring firm is concerned to arrive at a detailed assessment of the overall credit risk of immediate debtors and the overall customers of the business. If at all possible, the asset based lending firm would like to arrive at a credit assessment of the customers independent of their past credit performance with the business.