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What is Factoring?

Updated on November 17, 2009

Factoring is a service involving the purchase by a financial organization, called a factor, of receivables owed to manufacturers and distributors by their customers, with the factor assuming full credit and collection responsibilities. Those organizations that restrict their activities to extending advance payments to clients when goods are shipped are called old-line factors. Commercial finance companies and commercial banks also provide various factoring services as well as other methods of financing their clients.

Factoring should be distinguished from accounts receivable financing, in which a business firm retains its accounts receivable and obtains a loan secured by a pledge of those receivables.

Functions

A factor may perform two main functions for a business firm. In all cases he first acquires the accounts receivable generated by sales to customers whose credit standing he has checked and approved.

The first function, called maturity factoring, involves only the service benefits of factoring. In this function, the factor collects required payments directly from the customers, handles the necessary bookkeeping, and absorbs any bad-debt losses that may occur. For these services the factor charges the business firm selling its receivables a fee ranging from 0.75 to 2% of credit sales. The percentage depends upon the dollar volume, terms of trade, the number of transactions, and the risk of incurring bad-debt losses. Companies using only this function of the factor receive payment for their receivables shortiy after the average maturity date of each month's sales invoices. Even if a customer is late in paying the factor, the firm selling its receivables is paid by the factor at the agreed time.

A second function that may be performed by factors is to advance cash to the firm selling its receivables immediately upon shipment of the goods. This means that the firm selling its receivables does not need to wait, say 30 to 60 days, to receive cash for its receivables, as in the case of maturity factoring. The amount of the cash advance is usually about 90% of the invoice price. Since the factor is advancing money before he has collected funds from the receivables, he charges for this loan for the period of time from the date of the advance to the average invoice maturity date. Interest rates are usually a few points above, but tied to, the prime lending rate of New York banks. However, factors charge interest on daily balances and do not require the maintenance with them of minimum cash balances, as do most commercial banks.

Origins

Factoring is an ancient function. The Babylonian Code of Hammurabi covered certain trade practices of merchants' agents who guaranteed trade credits. The rapid growth of international trade from the Middle Ages through American colonial times went hand-in-hand with a growth in factoring. The role of factors in this era is illustrated by the "cotton-factors" in the United States in the early 19th century. Mills in England entrusted their products to these factors. Although they did not take title to the goods, the factors provided storage facilities, sold and delivered the merchandise, guaranteed the credits extended to buyers, and advanced funds to the mills against the receivables and consigned inventories. The initial concentration of these textile factors in New York has made it the factoring center of the nation.

As textile manufacturers became established in the United States, they no longer required the factor to handle storage, selling, and delivery. Consequently, these roles were gradually peeled away from the factor, leaving him with the functions of assuming credit and collection responsibilities as well as providing advances against purchased receivables.

Industry Structure

Factors later expanded far beyond the textile field and began to provide many other financial services. As a result the old-line factor diminished in relative importance. An important change has been the entry of commercial banks into the field. Although the First National Bank of Boston has provided factoring to its clients for many years, the modern rush into factoring began in 1965 with the purchase of Hubshman Factors by the First National City Bank, New York. Now large banks often have factoring departments.

Although the entry of commercial banks into factoring has made the field more competitive, it has also expanded the market for factoring to even more product lines. In earlier years some firms were loathe to factor their receivables because they feared that customers would doubt their financial strength. This hesitation has largely disappeared as more and more firms have come to accept factoring as simply another method of financing.

Economic Contribution

Factoring provides important economic benefits to business firms selling their receivables. The basic contribution might be termed "knowledgeable diversification of risk." The variety of receivables held by a factor provides greater diversification than is available to a firm in one line of business. Additionally, breadth of experience gives the factor an expertise in management of accounts receivable. These advantages are particularly apparent in export financing. Coupled with some economies of large-scale operation, these benefits permit a factor to perform the credit and collection functions at a lower cost than many of its clients could achieve. Factoring may be especially suitable for a firm with a highly seasonal business, since it would be uneconomical for it to support a credit department during slack periods.

Factors also provide financing that may not be available from other sources for small and rapidly expanding business firms. As sales expand, so do the immediately available funds from the factor. Once the firm has been able to build an adequate base of retained earnings, it may "graduate" to a less expensive, unsecured line of credit at a commercial bank. However, many companies continue to factor their receivables to obtain the credit services provided and to offer credit more freely than if forced to rely on their own expertise and resources.

Factoring firms offer a number of ancillary services to clients. Their knowledge of the market makes them helpful in planning budgets and sales projects. Some provide computer services that generate salesmen's commission reports, product or style analyses, or other kinds of information.

As the proportion of accounts  receivable to sales of manufacturers continues to expand, and as the variety of firms seeking factoring widens, it appears that factoring will continue to be an important means of financing economic growth.

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