There’s a new twist on accounts receivable financing
When businesses think of accounts receivable factoring, they can conjure up unpleasant thoughts of insensitive third parties beating on their hard-won customers for payment.
But most small business people know very little about factoring because it has historically been limited to certain industries such as textiles and apparel, and to larger companies. Recent technological and software advances have spawned factoring programs for smaller businesses that are strapped for cash.
Factoring has been used since colonial times in the Americas and even before that in Europe. Factoring involves the sale of accounts receivables to a factoring company. Prior to those sales, the factor will have approved the credit and set credit limits for the customers.
Thus, there are three parties in any factoring arrangement: (1) the seller who sells both the merchandise to (2) the customer and the receivable to (3) the factor.
Factoring arrangements can be set up for notification or non-notification, which governs whether the customer is notified that the account has been sold to the factor.
Also, factoring arrangements can be recourse or non-recourse. When the factor has recourse, the factor can look to the seller of the accounts receivable if the customer does not pay in 120 to 180 days. The non-recourse factoring arrangement has been the arrangement with which most business people are familiar.
The normal steps in the factoring of an account are:
invoices to the factor
Of course, the steps would be different if the customer didn’t pay or if there were some problem with the merchandise from the seller.
In the above process, the factor is performing four functions:
Small business factoring arrangements typically leave out some of those functions. While traditional factoring includes very much of a focus on credit and collection, small business factoring is much more focused on providing financing. Credit review and approval generally remains with the seller.
Since the factor has the account on its computer system, collection is often merely a series of letters to past-due accounts. Generally those arrangements are non-notification – the customers are not notified that the accounts are being handled by a factor. Whenever the factor does not perform the credit review and approval function, the factor retains full recourse to the seller for accounts that are not paid within 90 to 120 days.
Factoring can be a good tool for the rapidly growing small or startup business. It provides immediate cash flow at the time the sale is made. That cash flow can be used for traditional working capital uses such as purchasing inventory, paying subcontractors and employees, and covering operating expenses.
Because factoring does not create a corresponding liability on the seller’s balance sheet, it can enhance the seller’s ability to obtain credit from vendors. Even if the collection systems provided by the factor are minimal, they are often better than the seller’s internal systems and decrease the cost of the seller’s collection efforts. Since the factor makes its credit judgments based on the credit quality of both the seller and the seller’s customers, factoring often provides financing for sellers which can’t qualify for more traditional credit facilities.
One of the more innovative programs geared to smaller businesses is the Business Manager program developed by Private Business of Brentwood, Tenn. The program is designed for “community” banks, which means the smaller, independent banks. Over 1,700 banks nationwide, including several in southeastern Wisconsin, have installed the program.
The program includes software that tracks customer receivables. The software also generates collection letters and receivables management reports, including aging reports. Sellers can either fax or electronically transmit their invoices to the bank and have the money credited to their account within 24 hours.
The bank has full recourse and deducts the advance on any accounts that go 90 days beyond terms. Sellers can choose either to notify or not to notify their customers that the receivables have been factored. Sellers have on-line access to the status of their factoring accounts at the bank.
Milwaukee Western Bank has installed the program recently and already has 10 customers using it and averaging over $220,000 each in outstanding receivables under the program. Customers range from a heating contractor to a hardware store that has many industrial customers who require invoicing for the materials they purchase.
Dean Niemuth, vice president at Milwaukee Western, says that it gives the bank an opportunity to provide a credit facility to companies that otherwise might not qualify for traditional bank loans. Plus, he says that the program is flexible enough that it can be tailored to meet individual seller’s needs in terms of collection efforts and transparency to customers.
The cost to the seller ranges from 1% to 4% with the normal being in the 2% to 3% range, notes Niemuth.
Port Washington State Bank has been using the Business Manager program for more than two years and has 20 customers with average outstandings of $165,000. Its customer list includes manufacturers, building trades contractors, and an architect.
Keith Wetherell, vice president of Branch Lending, says that it has been a great program, especially for the bank’s rapid-growth customers. He says that the flexibility of the program allows the customers to sign up without any long-term commitment.
Jeff Larson, vice president at Grafton State Bank has been using the program for almost two years. He is using it for six customers with average outstandings of $100,000. He likes the program because it allows him to monitor the seller’s use of the credit facility as the seller issues invoices, rather than waiting for a borrowing base certificate that the borrower doesn’t usually send until the 15th or later in the following month.
Since late 1997, the FIPCO subsidiary of the Wisconsin Bankers Association has been marketing a similar product, Cash Flow Manager, to its member banks. While the association doesn’t have any banks in southeastern Wisconsin using the program yet, you should expect to see announcements of banks offering the program starting this year.
Factoring – or as these banks prefer to call it, accounts receivable financing – is no longer just for the big companies which want to fully outsource their credit and collection functions. Smaller businesses that need to free up some of their working capital should consider factoring.
Modern programs offered by banks today are much more geared to providing financing and are designed not to have the negative customer relations impact which was often associated with factoring in the past.
Additional information on factoring in this area and a list of Internet addresses is available on our web site at http://www.execpc.com/~devitt/.
Michael Devitt is president of Devitt Consulting Group in Shorewood. Small Business Times readers can contact him at 962-4414, or via e-mail at Devitt@execpc.com.
June 1998 Small Business Times, Milwaukee