Credit analysis and accounts receivable are an important part of managing cash flow and maintaining firm liquidity. For smaller firms managing credit and accounts receivable can be difficult. The expertise of management will often center on production and marketing, so that credit analysis and accounts receivable may be given less attention. Inexpert management of credit analysis and accounts receivable increases firm risk in two ways. One risk is that of inappropriate credit policies, resulting in significant bad debt losses due to overly lax credit policies, or in lost revenue due to excessively tight credit policies. A second risk is that even for profitable firms, and especially for young and growing firms, a liquidity crisis or lack of cash can occur if profits are excessively tied up as accounts receivable. One solution to the problem is to establish a credit department by hiring personnel who have expertise and experience in credit and accounts receivable management. For many firms, however, the cost of setting up and maintaining a credit department may be too expensive. An alternative is to obtain the services of a factor, an expert in credit management who will provide several services related to credit management.
One of the services provided by a factor is to essentially provide an external credit management department. When the firm receives an order, the information is sent to the factor for analysis. If the factor finds the credit risk acceptable, the firm will ship the goods and send an invoice to the customer. At the same time, the ownership of the accounts receivable is transferred to the factor. Usually, the customer will be instructed to send the payment directly to the factor. The factor will deduct a factoring commission, or charge for servicing the account, and forward the balance to the firm. Alternately, the customer may not be informed of the use of factoring, and the firm will receive the payment and send a fee to the factor. This arrangement is sometimes used because factoring is thought to indicate that the firm is in poor financial health, although more recently factoring has become more widely accepted. Note that the firm may accept the order and extend credit against the advice of the factor, but in this case the order lies outside the factoring arrangement.
Another service provided by the factor is risk assumption. The factor may accept ownership of the accounts receivable on a nonrecourse basis, taking full responsibility for collection. If the customer does not pay a receivable accepted on a nonrecourse basis, the factor will suffer the loss on the account. Under nonrecourse acceptance, the risk of nonpayment is shifted from the firm to the factor. The factor may alternately accept the account on a recourse basis. In this case the firm is ultimately liable for the payment of the receivable, and must pay for uncollectible receivables. Risk is not transferred under recourse acceptance.
In maturity factoring, the factor will forward the amount of the receivable to the firm as the receivables at the payment date. The factor may also extend credit by paying the firm a portion, usually 80 percent, of the amount of the accepted receivables immediately. This is called advance factoring and is equivalent to providing a loan to the firm using the receivables as collateral.
The factor will usually charge a fee of 1 to 3 percent of the amount of the receivable for providing credit analysis, collection, and losses on nonrecourse acceptances. The rate will be higher for nonrecourse acceptances than for recourse acceptances, and may depend on the credit quality of the accepted accounts and the volume of the accounts. A fee of 2 to 5 percent above the prime rate would also be charged on amounts provided under advance factoring.
Although factoring is generally considered to be expensive, it offers a number of advantages that may offset the high cost. The firm avoids the alternative cost of establishing and maintaining a credit department It also gains the expertise of the factor, with potential avoidance of bad debt losses or missed opportunities. Advance factoring provides a flow of cash that adjusts automatically to requirements, so that excess borrowing or emergency cash requirements do not occur. These advantages are especially important to smaller firms. Factoring is also particularly effective in foreign trade, where expertise and experience are of greater importance.
[ David E. Upton ]
Brigham, Eugene F., and Louis C. Gapenski. Financial Management. 8th ed. Fort Worth, TX: Dryden Press, 1997.
Moyer, R. Charles, James R. McGuigan, and William J. Kretlow. Contemporary Financial Management. 7th ed. Cincinnati: South-Western College Publishing, 1998.