Factoring is the financial practice of borrowing against a business’ receivables. Factors give companies the ability to tap into capital by advancing on money owed to them. According to an article written by Liza Casabona for WWD, factoring dates “as far back as 4,000 years ago during the reign of Hammurabi, a Mesopotamian king,” however, the “industry’s rise and evolution in the U.S. is more easily traceable through its ties to the textile industry in the 19th and 20th centuries.” Since factoring has such a long history, statistics, probabilities and likelihoods of events happening are common knowledge in the industry. Further, the factoring industry is fraught with fraud and is risky business. Successful factors do their homework; doing background checks, making the calls and verifying the truthfulness of information provided by potential clients. This is done in an effort to calculate risk to determine who to work with and how.
When analyzing a prospective client a factor will hang his or her hat on the credit worthiness of the prospective client’s debtor. While reviewing a debtor list, a factor will check on credit limits extended to them along with their payment history. From a statistics perspective, if the client has a history of paying late (and therefore lower credit limits) the likelihood of them paying their future debts is slim. A factor can eliminate future problems with a client by eliminating those debtors with a poor credit history and a likelihood of defaulting on his or her debt to the client/factor.
With a decent client list to work from the factor takes a step back and digs a little deeper and will review the credit worthiness of the prospective client. The factor will consider the following points:
1. Is the debtor base solid over all?
2. What is the relationship with the prospective client’s vendors, and do they pay them on time?
3. What does their accounts receivable aging look like and what are their collection percentages.
The consideration of the noted points are based on probabilities the likelihood of “X” happening. For instance, if the debtor base is based on a list of weak debtors with one very strong one; what is the likelihood of the company surviving should they lose the business of the large debtor? If the prospective client pays his vendors slowly and or owes a large outstanding amount of money, especially if money is consistently owed to vendors over 90 days, how long will their vendors allow this to happen before cutting him or her off, thereby cutting off the prospective clients potential to continue running his or her business. Conversely while reviewing an AR aging; if a prospective client has customers who consistently are allowed to pay late or if the client is carrying invoices more than 90 days, what is the likelihood of the outstanding payments to be collected/paid.
Given the long history of factoring statistical analysis has shown 90 days is the magical number. When a prospective client fails to collect his or her outstanding receivables in 90 days or under, the likelihood of him or her collecting at all increases. If a prospective client does not pay his or her vendors in 90 days or under they begin to jeopardize their vendor relationships and put his or her company at risk of losing a manufacturing lifeline. Through careful financial analysis and the calculation of gross profit margin, inventory and AR turnover, a factor can mitigate their risk be assessing the likelihood of the company being able to make money using a factor. If the company has sufficient gross profit margin, their inventory turns quickly as a result of consistent sales, and they can collect in a timely manner, the likelihood of a successful client/factor relationship is good and will result in positive growth and profits for both parties.