Traditionally a supplier makes a shipment or delivery and sends an invoice to the buyer. The buyer has the option to pay for the goods by the due date on the invoice, or, in many cases, to pay the invoice earlier at a discount.
However, under a conventional factoring agreement, the supplier makes the delivery and then sells its invoice(s) or accounts receivable (AR) to a third-party, often to a bank or financial institution known as a factor. The supplier receives a discounted portion of cash in advance of actual payment of the goods from the buyer. The factor receives a fee, often retaining a discounted portion of the gross invoice once it is paid. The fee to the factor covers its cost of processing invoices and collecting payments, as well as its lending cost of funds.
In all industries including the supply chain, conventional factoring is used to improve a supplier’s cash flow.
The factor rate or discount rate is the fee charged by the factor on a monthly basis, usually in the range of less than 1% and up to mid-single-digit percentages depending on the financial strength or credit worthiness of the supplier and its buyers. These fees can be a flat rate on the amount of the invoice or a stated rate if the invoice is paid in the first 30 or 60 days and a higher rate when payments arrive after the standard repayment period.
Suppliers can enter service agreements with factors under spot agreements in which the supplier can factor any number of invoices it chooses, or on a contract basis wherein the supplier is required to sell all or a large portion of its invoices to the factor. Some factors provide tiered fees offering volume discounts to suppliers that reach larger aggregate factoring thresholds monthly or quarterly, and some factoring companies allow contracts without minimums or usage requirements.
Most factors allow a supplier to finance 70-90% of its eligible accounts receivable, typically those due within 90 days. This percentage is also referred to as an advance rate. Similar to most forms of lending, an application and approval process exists. Most factors determine an advance rate based on the supplier’s quality of collateral, the credit worthiness and pay history of the buyer/customer, gross margins of the supplier, and dilution rate — the difference between the gross invoice or face value and what the customer actually pays on average. Breakage, returns, unused labor, etc. are examples of dilution.
The remaining portion of the invoice, usually 10-30%, is referred to as the reserve. The factoring company collects its fees upon payment of the invoice by the buyer and makes appropriate adjustments for dilution. The remaining reserve is disbursed back to the supplier, usually within a week of invoice payment.
Other fees or disbursements from the factor include wire transfers, automated clearing house (ACH) transactions, lockbox fees, late payments fees, collections fees, ongoing credit check fees of the supplier’s clients and fees for lower factoring activity than required by the agreed minimum.
Recourse versus nonrecourse
Factoring is similar to asset-based or collateralized lending but is not technically considered lending. In a factoring agreement, the owner of the invoice, the supplier in most instances, sells its invoice to the factor without the two parties entering into a traditional lending agreement in which a loan or line of credit is extended. This type of factoring is considered a “nonrecourse” agreement as the factor is the owner of the invoice, or debt, and has assumed the repayment risk from the supplier. The factor is now the owner of the buyer’s obligation to pay and bears the administration, collection and potential risk of nonpayment.
In a “recourse” agreement, the supplier retains the recourse and payment collection risk of its buyer. If the buyer fails to pay for the invoiced goods or services, the supplier is required to repurchase the unpaid invoice from the factor.
Factoring versus supply chain finance
Factoring is initiated on behalf of the supplier whereas supply chain finance or reverse factoring is a buyer-controlled early-pay finance program. In this case, the buyer establishes the relationship with a financial institution or funds the initiative themselves, paying invoices early in exchange for a discount to the face value of the invoice. The buyer invites suppliers to participate. Most large big-box retailers engage in supply chain finance programs with their suppliers and vendors.
Once in a supply chain finance program, the supplier can trade and sell its invoices to the financial institution for early payment, again receiving a discounted portion of the total invoice. In supply chain finance, the supplier usually receives the full amount of the invoice less the fee or discount for early payment, not an advance portion with the remainder to follow like in factoring. The supplier can decide which invoices they want to sell or trade on an a la carte basis versus some factoring agreements, which require the entire portfolio of accounts receivable to be sold or have minimum volume requirements.
Factoring for carriers
Factoring is used throughout the transportation and logistics industry. Many truckload (TL) carriers depend on factoring to bridge cash flow gaps when working with shippers that have longer payment cycles. Most TL fleets already operate on thin operating ratios (ORs) — the ratio measuring the percentage of operating expenses for each dollar of revenue — or the opposite of operating margin. Those that lack sufficient working capital and don’t qualify for credit lines turn to factoring as a means of funding their expenses.
ORs greater than 100% mean that more than $1 in operating expenses are incurred generating $1 of revenue.
There can be an even longer repayment period when carriers work through brokers for their loads. Shipper payments to brokers for delivered loads can take up 30 or 45 days, and then the carrier has another payment cycle with the broker.
Some truck brokers offer factoring services for advanced carrier payments or quick pays. Typical factor rates from brokers are 2% for advance of payment, or 98% of the agreed payment for delivery of the load compared to 100% of what may take a carrier a month-plus to receive. Some brokers waive the factoring fees for loads booked through their digital platforms or apps as a means of generating carrier loyalty.
Global factoring market
The total global factoring market is heavily fragmented, represented by more than 7,000 very large, well-capitalized global banks, middle market domestic banks and lending institutions, as well as online factoring and technology companies. The total global market is expected to reach $9.275 trillion by 2025, according to a report published by Adroit Market Research.
At its core, factoring is intended to shorten the payment of receivables or days sales outstanding (DSO) to the supplier, improving their cash flow. Most successful factoring relationships between supplier and factor are those in which the supplier operates a successful entity with a reasonably strong balance sheet, sells a product that is in high demand, and possesses a financially healthy customer base.