Introduction to Finance

Factoring Accounts Receivable 
Pledging involves borrowing against receivables 
balances; factoring involves selling the accounts. A fi nancing fi rm, or factor, purchases the accounts 
receivable outright and assumes all credit risks. Under 
maturity factoring
,
 
the fi rm selling its 
accounts receivable is paid on the normal collection date, or net due date, of the account. Under 
advance factoring
,
 
the factor pays the fi rm for its receivables before the account due date.
maturity factoring 
fi rm selling its 
receivables is paid on the normal 
collection date, or net due date, of 
the account
advance factoring 
factor pays the 
fi rm for its receivables before the 
account due date
15
Vipal Monga and Ruth Simon, “Banks Off er Smaller Companies an Indirect Route to Raising Cash,” 
The Wall 
Street Journal
, (October 27, 2015), accessed on February 5, 2016 at http://www.wsj.com/articles/banks-off er-smaller-
companies-an-indirect-route-to-raising-cash-1445903854.

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510
C H A PT E R 1 6 Short-Term Business Financing
Under a factoring arrangement, customers whose accounts are sold are notifi ed that their 
bills are payable to the factor. The task of collecting on the accounts is, therefore, shifted from 
the seller of the accounts to the factor. Some factors include GE Capital, Platinum Funding, 
and units of several large banks.
Factoring can be done 
with recourse
or 
without recourse
. With recourse, the factor can 
return an unpaid account to the fi rm and any funds advanced for that account must be returned 
to the factor. Without recourse, the accounts are sold to the factor and any bad or slow-paying 
accounts are the factor’s responsibility.
Rather than occasionally selling accounts to the factor, many times the factor becomes the 
fi rm’s partner. A typical arrangement has the factor become the fi rm’s credit department. That 
is, all requests to sell goods on credit to new and existing customers are routed to the factor 
for approval, saving the fi rm time and expense in hiring, training, staffi
ng, and running its own 
credit department. The factor’s credit department members must be prompt and accurate in 
their credit analyses and, because they work closely with the fi rm’s clients, must retain the 
goodwill of the companies that use its services.
Should the factor reject a credit request from a new customer of the fi rm or reject a request 
to increase an existing credit limit on an existing customer of the fi rm, the fi rm can always 
choose to extend the credit itself. In such cases, the fi rm will keep those accounts on its books 
and will have to service the accounts; meaning, to send bills, collect payments, and deal with 
any slow or nonpayers.
To use a factor, a contract is drawn establishing the duties and obligations of the seller 
and the factor. The contract provides that the accepted accounts be assigned to the factor for 
payment and that sales invoices to these customers, together with the original shipping docu-
ments, be delivered daily to the factor along with information on all credits, allowances, and 
returns of merchandise. 
The contract includes the conditions under which accounts may be sold to the factor, 
such as type of fi rm, the customer’s geographic area, and acceptable credit ratings. Another 
important part of the contract is the collection procedures to be followed in case a customer 
is slow in paying its bill. As we saw in Chapter 15, collecting accounts receivable can be a 
costly process, especially when a customer is alienated by aggressive collection eff orts. A fi rm 
will want to know what collection process the factor follows, as future sales may be lost if the 
factor is too aggressive.
The charge for factoring has two components. First, interest is charged on the money 
advanced. Second, a factoring commission, or service charge, is fi gured as a percentage of the 
face amount of the receivables. This charge typically ranges from 1.5 percent to 3 percent of the 
face amount of the accounts fi nanced. Factors will typically lend 80 percent of the remainder, 
although they may reduce the loan amount from 5 to 15 percent of the total amount of receiv-
ables factored to make adjustments, such as for merchandise that is returned to the seller. This 
portion of the receivables is returned to the seller if it is not needed for adjustment purposes.
For example, suppose a fi rm is owed $70,000 by a customer that rarely pays its bills 
any sooner than 60 days after the invoice. Assuming the customer meets the factor’s credit 
standards, the fi rm will receive 80 percent of the $70,000, or $56,000, within a day or two of 
accepting the account. If the interest rate for a 60-day account is 2 percent and the factoring 
fee is 3 percent, the cost of the factoring arrangement will be $3,500 (5 percent of $70,000). 
Assuming the customer pays its bill in full on day 60, the fi rm will receive an additional 
$10,500, which is the amount of the invoice ($70,000) less the advance ($56,000), less the 
combined factoring and interest costs ($3,500). Thus, the fi rm collects $66,500 of the original 
$70,000 invoice; $56,000 was received after a one- or two-day delay and the remainder was 
received at around day 60. 
Although a factor’s services may be used by a fi rm unable to secure fi nancing through 
customary channels, fi nancially strong companies may use these services to good advantage. 
In fact, factors are of greatest benefi t to companies enjoying strong sales and growth. During 
such periods, companies experience shortages of working capital. The sale of receivables 
without recourse (that is, sellers do not have to repay any funds received from the factor in the 
case of a bad debt) has the eff ect of substituting cash for accounts receivable. This may make 
greater growth and profi tability possible.
GLOBAL
Some fi rms factor their receivables for other reasons. First, the cost of doing 
business through credit sales is defi nite and can be determined in advance because the factor 

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16.5 Additional Varieties of Short-Term Financing
511
assumes all risks of collection. This is a form of credit insurance. Second, factoring eliminates 
expenses, including bookkeeping costs, the maintenance of a credit department, and the col-
lection of delinquent accounts. A further advantage, but of a less tangible nature, is that factor-
ing frees the management of a business from concern with fi nancial matters and permits it to 
concentrate on production and distribution. Factoring has become increasingly important in 
supporting export sales. A fi rm that is unfamiliar with the problems of fi nancing international 
shipments of goods is relieved of such details by factoring foreign receivables.
Although factoring services are regarded highly by some businesses, others object to 
their use. The two reasons cited most frequently are the cost and the implication of fi nancial 
weakness. The cost of factoring is higher than the cost of borrowing from a bank under the 
terms of an unsecured loan. However, concluding that the net cost of factoring is higher is 
diffi
cult. The elimination of overhead costs that would otherwise be necessary plus the reality 
that management need not concern itself with fi nancial matters may off set the additional cost 
involved in factoring.
Few industries are aff ected by factors as much as retailing. Factors guarantee payment to 
suppliers of many large retail fi rms. With such guarantees, suppliers ship goods to the retail-
ers, confi dent they will get paid. Should factors refuse to guarantee payments to suppliers 
because the factors believe a retailer to be on shaky fi nancial ground, a retailing fi rm can fi nd it 
has no merchandise to sell. Thus, predictions about poor fi nances can become a self-fulfi lling 
prophecy. Once one factor hesitates to stand behind a retailer’s credit, they all turn their backs 
on the retailer since no factor wants to be alone supporting a fi nancially troubled fi rm. Factors 
act as an early warning signal of a retailer’s real or imagined fi nancial deterioration. In 1995, 
Bradlees, a discount retailer, fi led for Chapter 11 bankruptcy protection after factors refused to 
guarantee Bradlees’ receivables to its suppliers. A few months later Caldor, another discount 
retailer, fi led for bankruptcy protection for the same reason: the factors would not support it. 
When factors refuse to accept a retailer’s credit, the retailer’s suppliers must decide whether 
to continue shipping and take the risk of nonpayment by the fi nancially troubled retailer or to 
stop shipping and possibly lose a client. With the bankruptcy fi lings, over time, of retail stores 
such as Federated Department Stores, Allied Stores, Macy’s, Jamesway, Bradlees, and Caldor, 
the suppliers may be listening to the factors.
16
It is not always retail outlets that close due to the inability to obtain factor fi nancing. In the 
Great Recession of 2007–2009, a lender and a factor were the victim of the slow economy; CIT 
Group fi led for bankruptcy protection in 2009. Prior to that, it was a large factor to many small 
businesses, franchisees, and participated in SBA lending.
17
Fortunately, the fi rm did recover 
from its bankruptcy fi ling and continues to fi nance businesses with loans and factoring services.
Pledging and factoring have many similarities. To help diff erentiate them,