W
hen your business receivables are of good quality, they are readily marketable to specialist financiers called factors. A factor buys your receivables at a discount, advancing cash as you make shipments, thereby freeing up most of your investment in A/R for more produc- tive uses. The factor also assumes most of your credit-related functions and can do so on a non-notification basis—that is, your customers are not aware that their receivable has been sold to the factor. Factoring is an attractive option if you need cash, but it is also somewhat expensive compared with other cash-generating alternatives. Because of the expense, which runs from about 3% to 10% of the A/R’s face value, it may be suitable for your company only if one or more of the follow- ing circumstances apply:■ you have no other choice due to lack of credit,for whatever reasons;
■ you can readily justify the cost by margins to be made on sales that would otherwise be forgone; or
■ you are in a business with severe seasonal fluctuations that make year-round A/R departments hard to justify.
There are two main reasons that factoring is often over- looked as a financing choice—cost and lack of knowledge.
Factoring is considered a last recourse because of its high cost.
On the other hand, the cost-savings potential associated with factoring effectively includes the outsourcing of most A/R func- tions as an integral part of the service.
For example, if you sell your receivables, you might need fewer people in your accounting department. In addition to the savings in salary and benefits, the space that the A/R staff formerly occu- pied can be used by employees who are more directly involved in producing rev- enue. Or you might be able to delay run- ning out of space and having to move to larger quarters.
One reason factoring is considered high-cost is that the wrong basis for cost comparison is often used. If A/R turns 12 times a year and your average net cost paid to the factor is 6% on each invoice, then the resulting 72%
seems high compared with borrowing from the bank at 10%.
The cost may still seem high after counting what you save, directly and indirectly by not having to maintain your own A/R staff. But since you are by definition strapped for cash to begin with, how would you pay the bank back? And if there is no ade- quate payback plan, what bank would lend you money in the first place? So, the bank at 10% versus the factor at 72% is real- ly not the appropriate comparison if bank financing is not avail- able. The real comparison should be with the additional dollars of contribution margin you earn on the incremental sales that you can ship because you don’thave to carry all the A/R balances.
A final note on cost comparisons: For a great many enterprises that do use factors, the only real alternative for raising addi- tional capital is selling equity, and even in cases where that choice is feasible, it is likely to be still more expensive.
The second major reason factoring is often overlooked as a financing option is simply a knowledge gap. Many people still think of factoring as a specialized tool for just the garment and
Many people still think of factoring as a specialized tool for just the garment and related industries, where it got its start.
But any firm with good-
quality receivables
from businesses or
government entities
can qualify for a
factoring relationship.
related industries, where it got its start. But any firm with good-quality receivables from businesses or government enti- ties can qualify for a factoring relationship. You should consid- er that option whenever conventional lower-cost methods are not available, or when the administrative A/R functions the fac- tor can perform are a priority for you. Most often, as men- tioned earlier, a high degree of seasonality in your order flow may make maintaining an adequate A/R function of your own too expensive on a year-round basis.
One way or another, whether on your own or through a factor, no sooner do you get on top of A/R management than you realize that you have almost as much money tied up in inventory as you did in A/R. Thus, we look next at swing fac- tor number two—inventory.
AVING DEALT SUCCESSFULLY WITH MANAGEMENT OF
your accounts receivable (A/R), you are now ready to ship another truckload of the fine products sitting in your inventory to good cus- tomers who will pay on time. As with A/R, inven- tory is also measured and calculated in days. Unlike A/R, which is based on sales dollars, inventory is denominated in cost-of- goods-sold dollars. The reason is simple. A/R represents sales that have already been made and so is related to sales. But what remains in inventory is, by definition, not yet sold, so it is both valued at cost and related to cost.
Inventory daysis the average number of days of production value and purchases sitting in inventory at the end of the peri- od. It is calculated by dividing end-of-year inventory dollars by the year’s cost-of-goods-sold dollars, then multiplying by 365 days. It may be helpful to think of inventory days as the aver- age number of days an item waits in inventory before it is sold and thereby converted from inventory to accounts receivable.
Inventory days tends to rise somewhat with the number of steps in the distribution channel. This is a natural consequence of the statistical inefficiencies required to maintain buffer stocks at more points along the distribution chain.
Another dimension of inventory days that needs to be con- sidered is where the company is in its business year when its