Factoring as a Credit Management Solution
Factoring is a financing tool which is not highly regarded in New Zealand. It’s perceived by some as a desperate effort to get some cash, no matter what the interest rate, from a lender of last resort. The people at Scottish Pacific Business Finance who came to tell me about factoring recently assure me that this is wrong; that their rates are competitive with bank overdraft rates after taking into account the banks’ penalty interest and 1.5% for provision of the overdraft facility; and that in other, more enlightened countries, factoring is seen as a perfectly normal finance option. For those who see stigma attached, Scottish Pacific will also consider undisclosed factoring - where the factoring is invisible to the borrower’s customers.
What I wanted to talk about was the credit management aspect of factoring, however, it’s necessary to explain briefly some of the charges and the way money is paid. In simple terms, a company hands over its invoices to a factoring company. In return it receives 80-90% of the face value of the invoices, and the rest when the debts are paid. It is charged interest equivalent to bank overdraft, plus a margin for risk, and a margin for administration. If debts are unpaid at 90 days, the factoring company has recourse against the creditor - that is, it asks for its money back. In addition, it will usually have a second debenture over the company.
Aside from the line of credit this provides, the company also gets billing and credit management services. (Or at least they can do. There are also options where the creditor still does the invoicing and/or collects the debts.)
The fact that the factor provides competent, timely follow-up on unpaid invoices is the most important credit management aspect of the service. This is something many businesses struggle with. Credit managers are always telling me that they would like to be able to call their overdue customers earlier but that they don’t have the time or the staff or systems. The factoring company’s job is to make sure they do have the time and staff and systems. The service is particularly useful to young, growing companies who get both an additional line of credit and a ready-made credit team. I presume that larger, more established companies who turn to factoring look to reduce their collection staff.
Non-recourse factoring is common overseas. If a major department store in the United States goes into bankruptcy, factors will probably be the largest unsecured creditors. However, in Australia and New Zealand there is no non-recourse factoring, with the important exception of export factoring. This is handled through correspondent factors.
Say you are selling to half a dozen American companies. You suggest to them that they should provide you with letters of credit and they ask why they should do this when your competitors will sell to them on open account. So you go to your New Zealand factor who arranges for an American factor to assess the creditworthiness of those companies, and if satisfied, to pay out on the invoices to those companies on a non-recourse basis. The fees are a little higher because of the extra link in the chain, but the extra benefit is that the US factoring company takes on the risk. Clearly this method of reducing the risk in export credit will be more expensive than its obvious alternative, credit insurance, but the financing aspect offers another dimension.
Selling bad debts is a different story. I covered this in a column last year ("Thar’s gold in them thar bills", July 1998). Baycorp is the major player - perhaps the only regular player - in this market. A change since I last wrote on the subject is that Baycorp is now starting to show an interest in younger debt and to pay more for it. Whereas in the past, they have looked for very old debt they could buy for a few cents in the dollar, now they are starting to buy younger debt for more interesting prices.
The other alternative which offers some of the benefits of factoring is the contract credit management services offered by many debt collection agencies. One issue that some creditors have concerns over is whether debt collection agency staff can demonstrate the right attitude to customers who may be only just overdue. If they spend most of your day taking a tough line with seriously overdue debtors, the argument goes, can they modify their approach to deal with our good customers.
Be that as it may, "ledger management" has been the catchcry in the debt collection industry for some time now. It would appear that more and more creditors are asking whether credit management is "core business" and whether they can simply contract it out to debt collection agencies or factoring companies.
Chartered Accountants Journal of New Zealand