Financing Alternative: Factoring Facts
Webster’s Definition
A Factor is “a person who carries on business transactions for another; a commission merchant; or the agent for the sale of goods.”
A Banker’s Definition
Factoring is the selling of accounts receivable on a contract basis by the business holding them, in order to obtain cash payment of the accounts, before their actual due date, to a specialized agency known as a Factor. The Factor then assumes full responsibility for credit analysis of new accounts, payment collection and credit losses.
Factoring differs from borrowing in that the accounts receivable and the responsibility for the collection are actually sold rather than merely offered as loan collateral. Factoring is a financing alternative used especially by highly seasonal industries.
A More People Friendly Definition
A business or individual, called the client, enters into a contract with a business or individual, called a Factor. The contract sets out terms of purchase for accounts receivable (invoices) not yet collected and currently held by the client. The Factor then takes on the responsibility of collecting payments from the customers and absorbing credit losses based on the terms of the contract. The Factor stands between the client and the customer giving the client money to continue business and collecting money from the customer as money comes due.
How Factors Make Money
Factors make most of their money in one of two ways: commission fees and lending fees. The client pays a commission fee to the Factor each time an invoice (receivable) is put under the “care” of or “sold” to the Factor. The Factor may also loan money to a client against outstanding accounts receivable or against inventory, for which they charge a lending fee.
Early History Of Factoring
Factoring is an ancient function found as far back as Babylonian times. The Babylonian Code of Hammurabi covered certain trade practices of merchants’ agents who guaranteed trade credits. This was the earliest recorded factoring.
A Factor, in early European history was defined as a representative, a man who looked after someone else’s business affairs. A noble lord would not conduct business transactions directly with those considered beneath them. His Factor would act as go between. The Factor would convey contracts, collect and disburse funds and see to transporting goods.
Prior to the 20th century, a Factor was a business agent whose functions included warehousing and selling the goods that were consigned to him, accounting to his clients about money collected, guaranteeing the credit of customers and sometimes making cash advances to his clients before the actual sale of the goods took place. His services were of particular value in foreign trade and for this reason Factors became important figures during colonial exploration and development.
Factoring In North American Colonial Times
The development of North America, from the end of the 18th century, required the flow of capital and know-how, much of which came from Europe. European exports of capital and goods were arranged along the traditional pattern: commission trade on a “friends and relations” basis. This meant that European merchants and manufacturers sent over sons and trusted relatives to strategic locations on the American continent, where they purchased and sold goods on commission for their European clients, friends and relatives.
The rapid growth of International trade in American colonial times spurred a growth in factoring. The Factor moved from being a relative to being a businessman who might handle many goods from many merchants.
The early Factors combined trading, banking, accounting and shipping to facilitate trade and open up new commercial frontiers. Several commission companies (Factors) were formed in New York and were backed by European merchants and producers in Manchester, Liverpool, London, Paris, Lyons, Zurich, Hamburg, Bremen, Cologne, Amsterdam, Rotterdam, Antwerp and numerous other trading cities.
Dealing in such port towns as Savannah, Charleston, Boston and New York, the Factors acted as a trade conduit for tobacco, cotton and indigo to the main commercial centers in Europe. The factors took risks for high profits, while the growers received a reduced payment for their goods before the goods actually reached the final buyer. Because the factors bought goods for highly discounted prices, they were often perceived as “shady,” greedy opportunists or somehow disreputable. Some even believed factoring was akin to loan sharking.
U.S. Cotton Factoring
The role of Factors is well illustrated by the “cotton-Factors” in the United States in the early 19th century. Cotton was exported from the South to New York and Europe. Eighty percent of the U.S. cotton crop was sent to Europe. Extended transportation and warehousing periods caused long delays from the harvest until the payment from the spinning mill. Thus, the need for the Factor to advance money against orders to the growers so the growers could continue operations, instead of waiting for the cotton to arrive at its destination and the funds to travel back to them.
The transportation and the sales were performed in stages: from plantation or farm to a trading town in the interior or on a navigable river; from there, directly or indirectly, to an export port on the seaboard like New Orleans or Savannah. There is still an historic area in Savannah near the river called Factors Walk. From the export port the cotton was shipped to New York for its ultimate destination, Europe.
Transportation of the cotton bales was directed and financed by a network of specialized cotton Factors. The cotton was sold on commission to Factors up the chain. Advances were granted and taken with the money coming from the export Factors. These advances were often financed by Factors that operated in importing countries or in another country rich in capital.
Post Civil War Factoring
After the Civil War, direct contacts between buyers and spinning mills and direct transport to the mills and consumer markets were increased. These changes were brought about by improved communication (railroads, mail services and telephones). 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 removed from the Factors, leaving them with the functions of assuming credit and collection responsibilities, as well as providing advances against receivables. Factoring moved out into other industries, but the old style Factor diminished in importance.
The Factor/Bank Connection
Factoring in the U.S. gradually adapted to specialized financial and administrative services. Although the First National Bank of Boston provided factoring to its clients for many years, the modern rush into factoring didn’t begin until 1965 when the First National City Bank in New York bought Hubschman Factors and the Factor/bank relationship was born. The financial strength and respectability provided by the bank gave the Factor an ability to be more competitive, expand their markets to more product lines and lent a level of respectability to the factoring of receivables. Today factoring is accepted as just another financing alternative.
Why Factor?
For many of those using factoring today, receivables provide them with an additional asset to leverage for funds. For others, factoring provides a diversification of risk. The variety of receivables held by a Factor provides greater diversification than is possible for a firm in one line of business. Factors also provide a level of expertise in management of accounts receivable. Businesses with seasonal sales can leverage the benefits of a Factor’s accounts receivable management system and do not have the cost of a credit or collections department within their business.
Factors provide financing alternatives that may not be available from usual sources for small and rapidly expanding businesses. As sales expand, so do the immediately available funds from the Factor. Once the firm has been able to build an adequate base of earnings, it may move to a less expensive, unsecured line of credit at a commercial bank. The Factor is often a temporary necessity. However, many companies continue to Factor their receivables to obtain the credit services provided and to offer credit more freely than if they were to rely on their own expertise and resources.
Factoring Evolution
Factoring continues to change and evolve. The larger brick and mortar Factors have, just as banks, been combining to form even larger Factors. Competition for market share is as fierce as ever. The types of businesses using factoring are expanding, becoming more technology based and factoring internationally is growing. Factoring is indeed alive and well today. With the speed and agility of Internet technology, it is possible to access online based Factors who will take an application, review your invoices and. upon approval, factor eighty percent (or more) of each invoice back to you in capital-without ever seeing your face.
If you are a small growing business with orders to fill and invoices to leverage, you may be able to obtain operating capital through a Factor, using it as a financing alternative. If you do an online search, use the term factoring rather than factor. Accompany the term with your state to limit the returns, if you want to stay local with your business. Do check out any organization stating they are in the factoring business to be sure they are reputable. Remember that factoring was long believed akin to loan sharking and there are still some “carpetbaggers” out there.
