From time to time our agency is requested to be the “back-up servicer” on asset-based loans that have become past due. The term, “back-up servicer,” is a nice way of saying “third party collection platform.” We are also at times the collection platform for factoring when commercial invoices have not been paid. As a collection entity functioning at times within a complex credit risk management system, allow me to offer my understanding of the differences between asset based lending and factoring financing options.
To begin, as you probably know, standard bank loans are usually offered to well-established companies with a proven history of sound revenue and profits. Realistically however, many companies do not produce stellar results, and often operate in unstable markets.
Consider companies in the staffing or apparel industries which have cyclical periods based on the seasons; or a startup company with potential blue-chip clients but no business history; or a machine shop that can’t afford to wait 60-90 days for its vendors to pay but needs to purchase materials to keep production running. Even though these companies may not be candidates for traditional loans, non-financial institution financing options are usually available.
Although asset-based lending (ABL) and factoring both use accounts receivable as the primary source of collateral to provide working capital during cash flow crunches, there are some basic differences.
ABL is a loan that a business owner can access when needed. The loan amount is based on the liquid value of the company’s assets, which are used as collateral. Assets usually include inventory, accounts receivable, machinery, equipment, and fixed assets such as office and factory buildings. Since assets are the basis for the loan, ABL is a great option for a business that has a fair amount of inventory, accounts receivable, and equipment. At the same time, in the event that the business defaults and/or goes bankrupt, the loan places the lender into a secured creditor position and the collateral is mostly liquidated to satisfy any remaining loan balance.
The biggest benefit of ABL is that since the loan is based on the liquidity value of its operating and fixed assets, even during temporary economic downturns and seasonal fluctuations, the collateral value generally remains stable, guaranteeing the loan amount available.
Factoring (also called accounts receivable financing) on the other hand is a good option when a company needs to extend payment terms to its customers far beyond 30-45 days. For example, many suppliers to the big-box chains like Walmart and Target use factoring since their invoices may not get paid for even up to 120 days. In short, factoring is a cash advance on the receivables. It is not a loan and there is no monthly repayment.
Working with a factor does have some advantages. It can free up the client from the collection process and allow the factor to take over the management of the receivables. This in turn can often reduce administration costs. At the same time, depending on the market interest rate and the number of invoices per month that need to be factored, a factor may advance between 80-95 percent of the invoice value. When the factor collects the full amount, a service fee (typically ranging from 1-3 percent of the invoice) is taken, and the client receives the balance.
Although factoring basically involves selling invoices to the factor, the business owner does not give up any equity or other ownership control in the company.
Recourse and non-recourse factoring options are also available. Under recourse factoring, if the customer fails to pay an invoice then the cash advance on that invoice needs to be returned. Under non-recourse factoring, if the customer fails to pay an invoice the factor does not ask the client to return any cash advance but rather attempts to collect by themselves or use a third-party collection partner.
Here are the benefits of each financing option at a glance.
- Easier to obtain than traditional loans
- Based on the liquidity value of the assets
- Not all assets need to be collateralized
- Does not usually require projected earnings forecasts
- Flexible and seasonal advances make it attractive
- It is not a loan and there is no debt accumulation
- Does not require projected earnings forecasts
- Scalable and flexible depending on the number of invoices
- Can commence very quickly
- Administrative support provided and reduced admin costs
Regardless of wherever within the credit risk management system you are working, understanding if your customer is utilizing ABL or factoring is another part of the credit evaluation that may play a role in how your company ultimately provides credit to them.
Your questions and comments are most welcome (firstname.lastname@example.org).
Nancy Seiverd, President, CMI Credit Mediators, Inc.