Factors To Consider

Few people outside the business understand factoring, but it's a time-tested way to increase your cash flow when your capital is low and accounts receivable are high.

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Among the oddities of the present state of the economy is that in the midst of plenty, commercial lenders are losing ground. Not only are their loans going sour, but so is the collateral behind them. This past summer, for instance, BankAmerica Corp. reported a record $640-million quarterly loss, and began monitoring its loan decisions more carefully. The customers of one of the country's mightiest financial institutions were forced to work harder for short-term working capital, or to look elsewhere. Some need only look to one of the country's humblest financial institutions, the hundred or so firms that constitute the ancient, and for the most part honorable, community of factors. Presuming, of course, the businesses understand that in many cases even a healthy operation can adapt factoring -- once considered the loan of last resort -- to its short-term advantage.

And there's the rub: factors remain underappreciated, even after three dozen centuries. A survey last year by Dun & Bradstreet Credit Services of 1,060 companies of various sizes disclosed that only 7% dealt with factoring firms -- or admitted to it. The aloofness of the other 93% was no doubt tinted by the popular view of factors as a pack of usurious Indian-givers who prey on desperate, capital-needy enterprises for quick profit. Some years ago, this appraisal was warranted to a degree, but as such reputable institutions as Manufacturers Hanover Corp. and The Fuji Bank opened above-board factoring divisions as a complement to conventional banking, factors have regained some respectability.

One reason for widespread ignorance of the financing technique of purchasing a company's receivables is that until recently most domestic factoring rode the coattails of the apparel trade, a sector whose growth was in large part spurred by factor underwriting. Another reason is that formulas for filtering capital through a factor are not standardized; the terms of a standard collateralized loan are often easier to pin down. Third, some so-called factors add to the confusion by selling themselves as factors even though they really do accounts-receivable financing -- a similar but separate service (see box, "Accounts Receivable Financing," page 136).

None of which ought to stop a business from at least considering a factor to solve short-term cash-flow bottlenecks, especially now that the core of the factoring industry is looking to expand beyond the patchwork clothing trade. Indeed, the financial force that kept garments from folding through the years applies to any enterprise that accumulates receivables. And though the terms may sometimes seem outrageous, they can foster growth better than traditional borrowing. "If you use a bank, you can do volume of 6 to 8 times your capital; factored, you can do 10 to 14 times capital," says Barry M. Pearl, vice-president and director of marketing of BT Factors, a $1.6-billion (in 1985 factoring volume) adjunct of Bankers Trust Co. in New York and among the 10 largest factors in the nation. How is this minor miracle wrought? "You're getting a much better cash flow," explains Pearl. "You can buy better, pay your bills faster, and get more credit." Furthermore, by committing only its receivables, the other assets of the firm remain as possible collateral for additional borrowing.

The factor issues credit at shipment, based on the amount of invoices cut by the borrower; on any given day, the greater the dollar amount of the receivables, the higher the credit line. At a bank, however, to enhance a similar credit line based on receivables pledged as assets, the line and the paper behind it would have to be reconsidered periodically -- if at all. "The more I talk to my banker friends, the more I am convinced that the banks really don't care about the smaller borrower anymore," observes Walter Kaye, founder of Merchant Factors Corp., a $40-million New York City firm begat of garments in 1985 and now moving into other small businesses. "They can't make any money. Their overheads are huge. It takes the same officer, the same time, the same policing, to put on a million-dollar loan as it does a quarter-million-dollar loan. They want it collateralized by outside assets they can touch and feel. They love real estate."

His conclusion is not entirely self-serving. Banks are not in the collection business, and would be unlikely to take on asset-based financing as their sole function to a customer. They would expect the rest of that customer's banking business as well. But not factors, who exist comfortably enough outside banking regulations and are thus free of the strictures of the system; factors want only that function, and the borrower need not mortgage its soul. "If an account is marginal, in tough times he won't get a bank to loan him anything," observes BT Factors's Pearl. "We are more liberal." Which makes a factor sound a bit like Santa Claus. Fat chance: a factor takes risks, and with risk there must be compensating reward.

Factors make their profits by acquiring a company's invoices and collecting on them, charging the company a fee. Simply put, there are two variations. One derives the fee by discounting up front the face value of the invoices; the other by lending against the receivables until they are collected, charging daily interest on the open amount plus a onetime commission. Either way, the essential point is that, unlike a bank, the factor buys, pays for, and owns the receivables outright. The risk is that if they go bad, the factor suffers the loss.

If they don't go bad, the reward is that a factor's return on investment can exceed conventional lenders' returns. To cement that happy ending, factors execute thorough credit checks on each debtor before buying the invoice from the issuer. Indeed, unlike banks, to some factors the financial condition of the latter hardly matters. "We do not look toward the business that comes to us selling its receivables, but to the strength of the receivables it is selling. The capitalization of the business is not crucial," says David B. Clark, founder and partner of a West Coast group of independent financial firms doing $200 million a year.

A wide-ranging financier with specialties in oil, aerospace, importing, and transportation, Clark currently discounts his purchases by about 6%. That is to say, for every $1,000 in receivables, the seller receives $940, and the deal is done. While a few scatered factors discount according to a schedule, paying a smaller percentage up front and throwing in more depending on whether the receivable is collected within 30, 60, or 90 days, Clark's is a onetime charge. The factor then takes over the entire collection process, including mailing out the invoices. Each customer is notified that the account is owned by and payable to the factor. If the factor gets the check in 45 days, essentially the client has been charged 4% a month. If the businessperson continued to sell his receivables on the same basis, over the course of a year, he would be paying 48% for the early use of money.

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