Chapter 12 -
To factor or not to factor

Just sell your accounts receivable; that way you don’t have to collect the money owed to you.” It’s an enticing pitch, but don’t get caught taking the easy way out unless you absolutely need to and you understand all the ramifications. Each situation is unique, and you must fully understand what you are getting into before choosing to factor.

What is factoring?
Factoring is the process of selling your accounts receivable to a third-party financing source. Typically, you will bill the shipper and then turn over a copy of the invoice to a factoring company. At that point, the factoring company will advance you 80 percent of the gross amount of the invoice less a percentage kept by the factoring company. The factoring company is now responsible for collecting the amount on the invoice from the shipper. When the amount is collected, the factoring company will send you the remaining amount of the invoice, minus another fee, perhaps.

The concept of selling accounts receivable has become more popular recently after years of being considered taboo. Just because it has become more popular, however, doesn’t mean it’s for you.

Should I factor?
Most factoring situations are necessary for emergency cash when all other disciplined accounting practices and financing options have been exhausted. Later in this chapter, we will compare traditional financing with factoring.

Pros

• Instant cash – The biggest advantage to factoring is availability of instant cash. You could receive up to 80 percent of your invoice in as little as three hours after the actual delivery.
• Faster collections – In effect, factoring nominally speeds up a percentage of your collections. If a crisis arises, you can accelerate your collections to meet immediate cash requirements. If a large shipper declares bankruptcy, you either will lose its accounts receivable or see a severe delay. You can accelerate your other shippers’ accounts receivable to make up for the shortfall from your troubled customer.
• Reduced bad debt – After you factor your accounts receivable “without resource” and receive your 80 percent, it’s now the factoring company’s responsibility to collect the balance. If you factor “with recourse,” you still will be slammed with the bad debt. Make sure you know which type applies. If the factoring company pays you without recourse, it’s more expensive, but you have greater security.
• Credit checks – Factoring companies generally accept invoices only for your customers with good credit. If your factoring company denies an invoice, this might be a warning that you should stop serving this shipper.
• Professional collection – Factoring companies are pros at collecting debt; it’s their business.
• No balance sheet effect – Done without recourse, factoring is not recorded on your balance sheet. If third parties use your balance sheet to evaluate other financing opportunities, factoring will not adversely affect your balance sheet. But realize that these receivables can no longer be used as collateral for other loans.
• Cash for growth – Factoring provides cash necessary to expand your company, especially if you have been trying to expand and just can’t get to the critical size you’ve been shooting for.

Cons

• Instant cash (but it costs you) – How much cash would you receive? Remember, you may never receive the other 20 percent of the invoice. The factoring company’s fees depend on how quickly it collects the invoices. More than 60 days could cost you up to 10 percent of the total amount. With 6 percent profit margin, this could put you in the red. The factoring company will take a certain part of the fee immediately from the 80 percent that it forwards to you in some cases.
• Faster collections are temporary – The immediate source of cash is only temporary. What happens next week or month if you factor a large part of your accounts receivable and receive cash for your immediate disbursements? If you have lost a customer, have slow-paying customers or just need cash, the cause has not gone away. You have treated only the effect, not the cause.
• Won’t automatically reduce bad debt – Most factoring companies won’t accept credit-unworthy invoices anyway. At first you may slip in one or two customers, but not for long. The factoring company wants the invoices that you don’t have any problem collecting now.
• Credit checks are easy to obtain – Factoring companies will perform credit checks because they don’t want bad customers either. This is a function you should perform anyway. Credit checks are easy and don’t require a factoring company. Don’t pay for services that are free or for information you already should know.
• Is professional collection necessary? – If you are screening your customers, you won’t need professional collections. You will, from time to time, encounter a problem shipper even with a customer screening system, but do you really need to pay up to 10 percent of the invoice to collect late payments? Remember, very few factoring companies will accept an invoice more than 90 or 120 days past due.
• Other financial-statement effects – Factoring is not recorded on the balance sheet, but it definitely will affect your P&L statement. Factoring costs 2 to 9 percent of your factored revenue, depending on invoice age.
• Cash for growth, not for profit – Cash for growth is one of the most commonly touted reasons for factoring. Factoring companies often show how they can improve your net profit by helping you grow. Don’t assume that cash will help you grow enough to improve your net income. Also, many factoring companies use 2 percent as the example of factoring costs. This percentage is the fee for receivables collected in less than 30 days. Factoring these accounts is not necessary.

Example of factoring
Suppose that your receivables average 50 to 60 days. If the factoring company can’t improve this average, your cost of factoring will be enormous.

As you can see in Table 12-1, CCU Trucking had no growth at all; factoring simply added approximately $400,000 in expenses to outsource the billing-and-collections function. There might be some significant internal cost savings to offset some of this, and you should obtain a good estimate. But by using a revolving bank loan line of credit and installing and maintaining good internal accounting controls, your similar bank loan interest cost might be $300,000 or more less than the cost of factoring. You should consider further savings in factoring costs if the factoring company can improve your collection period days.

While these examples may be extreme, they illustrate the decision process you must undertake to compare apples to apples in deciding between bank financing or factoring.

In the end, factoring makes sense if you (a) can’t or don’t want to invest in tight internal accounting systems and competent personnel or (b) want to grow dramatically and outsource your receivables functions.

Investigating a factoring company
Companies and available arrangements differ. Choosing the right option takes some research:

1. Define your needs. The first step is defining your requirements. Each company offers different advantages; it’s best to define what you want so that you aren’t basing the decision on price or hype.
2. Identify at least three companies. Search the Internet or check with your trucking associations for references. Don’t limit your search to the first company you find.
3. Research these companies. Once you have a collection of companies, contact the companies and tell them you are interested in factoring your accounts receivable. Ask for the requirements and for basic information about each company.
4. Ask for collections statistics. After reviewing the basic information, ask each company for statistics on its collection process. You will benefit only if the company can collect from your customers. Otherwise, you may get only 80 percent of all your receipts. Also, you want your factoring company to add value to your company by collecting your difficult accounts.
5. Ask the company to run sample scenarios. The only way to get an understanding of your potential relationship is to have each company prepare a sample scenario of your company.
6. Get a second opinion. After your basic research is complete, ask a CPA or financial consultant to analyze your various proposals. They probably will spot things you overlooked.
7. Ask for references. Any factoring company worthy of your business will have happy, satisfied customers that will relate their experience.
8. Negotiate. Nothing is written in stone.
9. Start slow and develop a relationship. As you factor accounts, you will want to start slow even if you are in an emergency. You are taking on a partner in your business, and that process takes time to develop.

In Summary
You can use factoring for emergency cash or fast-growth cash. For long-term cash flow solutions, you need some of the internal systems outlined in this book. Factoring has its place, but it’s not a cure-all for a
poorly run business.