What Due Diligence?

In Factoring deals, the most important aspect is the due diligence conducted by the factoring company on its prospective client and on the client’s customer to whom the invoice was sent. This is because the client’s customer is the ultimate payor. The willingness of the Factor to purchase the invoice at a discount from its face value and to receive full reimbursement from the ultimate payor, is based on risk assessment.

In other words, is the client and the client’s customer worth the risk?

Frequently, SAW gets clients whining that the Factor is asking too many questions, or the questions are too intrusive about the company’s operations, or why is it necessary for Directors to disclose information about themselves and their finances? (the answer is to determine whether the Directors might be stripping the company to line their pockets).

Yet when a bank asks those questions – and more – just for a loan, the Directors meekly comply. After all it’s a “bank” right? The notion that an institution like a “bank” and all its credit checks, is somehow more “authoritative” and “trustworthy” than a private funding source, runs very deep.

And it is deeply misplaced.

The banks’ role in the residential sub-prime drama is history. What is now unfolding is Stage 2: the banks’ and their co-conspirators compounded greed in the exotic securitization and creation of mortgage-backed, debt-fuelled instruments with purportedly stellar credit ratings. These are now unraveling with billions of dollars of losses in the pipeline.

To say that consumers and SMEs have been hurt by the sudden indefinite contraction in credit, is an understatement. What’s really galling is the utterly feckless credit risk analysis supposedly undertaken by banks, investment banks and credit rating agencies as they fell over themselves to slice and dice these securitized instruments in order to push them onto hedge funds and other “sophisticated investors”.

It’s clear that the credit risk analysis of inherently dodgy instruments was a sham at worst, a formality at best. A nudge and a wink was the order of the day at Wall Street. And they have very thick skins. The effect of shoddy and virtually non-existent risk analysis is now blamed on a computer error. That error apparently led Moody’s to assign Triple-A ratings to billions of dollars worth of complex debt product. The error was discovered in 2007, but the debt instruments’ AAA credit ratings remained until early 2008. And it doesn’t end there. The suspicion is that Moody’s may have tweaked its computer model to arrive at the same result as Standard & Poors, in order to keep business as “a second opinion”.

Of course, Moody’s is now doing “a thorough review” of its derivatives ratings.

To which SAW would add, Really?? A computer error that lasted errr……………….7 years???!! Remember it was after US interest rates were slashed in September 2001 that sub-prime mortgages and their securitized derivatives took off.

So….back to Factoring companies and the questions they take the trouble to ask during due diligence. SAW’s humble advice is to stop complaining, be grateful they’re doing their job (properly) and answer their questions fully.

Your future cash flow depends on it

© 2008 Sanjeev Aaron Williams All Rights Reserved

Stating The Obvious

“If you’re a smaller player, you need more capital to do business in tough times. They now need to show that they can keep churning profits in this environment”

David Hendler, CreditSights analyst, quoted in the Business News, South China Morning Post, 2 April 2008.

He might as well have been talking about SMEs. He was actually talking about Lehman Brothers having raised US$4Billion from a special offering of 4 million shares. The proceeds are slated to increase its capital base and provide greater financial flexibility.

Sounds familiar doesn’t it? Some of the best known names on Wall Street are scrambling to raise working capital and giving up equity to outside shareholders, despite the bravado.

Whilst this blog is not exclusively about Factoring, the pain on Wall Street is a nice contrast to Factoring, the potential benefits of which can be found by going to the Labels column on the Right Hand Side of this blog.

© 2008 Sanjeev Aaron Williams All Rights Reserved

Manna From Heaven

“Leveraged risk is a cancer in the market”

So reported the online edition of the British newspaper Telegraph on 7 March 2008, apparently quoting UBS (and they should know, right?)

SAW decided to keep that quote, figuring that something would pan out in the coming days – and it did. First, the default and collapse of Carlyle Capital and then………. Bear Stearns, Wall Street’s fifth largest investment bank, nearly panned out, following a loss of confidence by hedge fund clients who withdrew their cash. All this against an accelerating backdrop of rumour and innuendo from 6 March 2008 that European banks, fixed income and stock traders had stopped trading with Bear because it was having trouble with daily liquidity and that it was not receiving short term financing from banks. You just knew something was very wrong.

By 15 March 2008, despite repeated statements from Bear executives that solvency was not an issue (the real clue that it really was), the US Federal Reserve and J. P Morgan Chase stepped in with an emergency cash lifeline for 28 days. The Wall Street Journal’s online report for 15 March 2008 spells out the sequence of events.

Since Bear is technically an investment bank and not a commercial bank, it could not receive the money directly from the Fed. Instead, the Fed lent the money to J.P.Morgan, a commercial bank, who then re-lent it to Bear. The Fed assumes the risk of default.

So what are the lessons in all this for SMEs?

• You don’t have, or at least you shouldn’t be having, the apparent luxury of massive debt to equity ratios. One of the more astounding facts to come out of Wall Street last week was the revelation that companies like Bear were leveraged in mortgage-related derivatives at 32 times equity. That’s a fancy way of saying that you have one dollar in your left pocket, but you owe 32 bucks from your right pocket – and you don’t have any cash flow. How long do you think you could survive?

• The more complex the derivatives, the deeper and more pervasive the risk of default. Let’s make one thing very clear. There is a difference between the sub-prime residential and other “asset” backed (read plasma screen TVs) mortgages – which are theoretically quantifiable, and the mountain of structured finance (read paper transactions) which sliced, diced, chopped and pureed these mortgages into ever more sophisticated and ultimately toxic cocktails whose value is unknown – except for the blatant fact that whatever it was, it ain’t now.

• By way of contrast to (1) and (2) above, the sale of Invoices through Factoring does not result in debt. First, it improves your debt to equity ratio. Second, it improves your Balance Sheet (because the Invoices, which are listed as Current Assets, are converted into cash). Third, it improves your cash flow. Funny how Wall Street titans forgot that the more dodgy the security, the worse your cash flow, the Balance Sheet and debt to equity ratio. Pretty basic stuff.

• For an SME, the unpaid commercial invoice is a quantifiable asset. The due diligence that the funding source does on the client and the ultimate payor ,is the assessment of risk to determine manageability. It's a tried and tested recipe without dubious notions of "mark to model" valuations.

• And the rumour and the innuendo? SMEs are sometimes concerned that Factoring will damage their reputation or give the impression that they are financially unstable. It’s well known that Fortune 500 companies factor to improve their cash flow. An SME that is cognizant enough to guarantee its cash flow through factoring, capitalize on the time value of money and ensure that Receivables outperform Payables, will be the subject of one kind of rumour. Smart.

© 2008 Sanjeev Aaron Williams

Lessons Learned

This blog has dealt extensively with sub-prime. But how does all that relate to private SMEs who are interested in improving their cash flow for the purposes of growth or survival? What lessons can be learned?

1. Surrender of Equity

Factoring does not involve going to foreign investors - Sovereign Wealth Funds in particular - and giving up, or issuing, equity in the company. Just ask Citigroup or Merrill Lynch.

2. Management Changes

The funding source will not demand management changes at Board level as a condition of funding (unless there’s suspected or actual fraud).

3. Debt-Free vs. Debt

Factoring is effectively debt-free growth for the company. It is based on the SALE of the commercial invoice to the factoring company. That invoice, which represents future cash, is a genuine asset. The factor buys it from the company at a discount from its face value and the company gets cash almost immediately. The factor then looks to the company’s ultimate debtor for payment of the full face value of the invoice.

Sub-prime was debt-ridden at all levels with catastrophic results. For the lenders, the “assets” of the individual debtors were either cars or plasma TV sets (which have no residual value) or the assumed ever-increasing value of a home which they knew fully well the debtor could not afford. The basis of sub-prime rested on loading credit challenged individuals with even more debt and then repackaging the “assets” as “safe” corporate investments for Wall Street and beyond.

4. Credit-Worthiness

Factoring is strongly dependent on the credit-worthiness of the company’s ultimate debtor. This is because the ultimate debtor remains liable to the funding source for the face value of the invoice. That is why factoring companies who are buying the invoices, demand to know details of a company’s debtors and run checks on them, including verifying that the invoice issued to the debtor is genuine. If the factor has doubts on the credit-worthiness of the ultimate debtor, funding for those invoices will be refused. Period.

One of the hallmarks of the sub-prime fiasco was that the credit-worthiness of the individual debtor, who often had a lousy credit rating to start with, was fudged or dishonestly recorded to make it appear better than it was. Everybody knew what was going on and simply turned a blind eye. Risk was compounded.

Factoring seeks to minimize uncertainty on 2 fronts: for the company seeking guaranteed predictable cash flow; and for the funding source that assumes the risk of repayment from the ultimate corporate debtor.

© 2008 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The Hard Truth

Frequently, companies moan that the cost of factoring is too high. Fine. In some situations, it is and would not be the best option. SAW has told companies to forget factoring and try something else.

A personal rule of thumb:

• A business with gross profit margins of less than 15%: forget it

• A business with gross profit margins of 15% - 20%: possible

• A business with gross profit margins of 20% or more: ideal

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The Personal Guarantee

Many company directors choke when they look at the factoring documentation package and see the requirement for them to sign a Personal Guarantee. Some walk away from the deal altogether, claiming they’ve made enough disclosure. Others say the Personal Guarantee reeks of traditional bank financing.

Let’s make one thing very clear. Corporations, by themselves, don’t commit fraud. It’s the people behind them. The Personal Guarantee is the factor’s safeguard against fraud – and not, as is commonly assumed, an alternative means of recovering payment by going after an individual.

Factors carry credit insurance in respect of funds that they advance on a non-recourse basis. Many factors advance funds pursuant to a Line of Credit that they have with their banks. As a condition of the credit insurance and the bank Line Of Credit, factors are required to obtain a Personal Guarantee from the directors of their customers.

As and when the factor has funded an invoice for which it has not been paid by the ultimate debtor, it is far cheaper to simply off-set the amount against future advances, rather than resorting to litigation via the Personal Guarantee.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

What The Factor Wants To Know

Is There A Real Need For The Factoring?
Where in the business has the need for cash flow arisen? Fulfilling orders? Tax problems? Looming payroll? Inability to pay suppliers? What exactly?

When Does The Business Need The Cash Flow?
If it is needed to fulfil an expected contract, when will the contract be awarded?
When is the next payroll due?
By when do you have to pay your suppliers?

Just How Good Are Your Debtors?
Factoring is all about the creditworthiness of the debtors – the ultimate payors of the factored invoice. Factoring companies act as a Receivables Management function – they are not in the business of delinquent debt collection. There is a huge difference (and it is a different kind of financing).

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The First 3 Months Of The Year

It may come as a surprise to realize that January, February and March are difficult for businesses, even during good times. Why?

During these months, companies analyze and plan their objectives for the year. It might include expansion of product lines, production facilities, more employees, upgrading the marketing.

The company needs to project where the additional funding will be coming from, while still having cash on hand to pay expenses incurred at the end of the proceeding year. It is important to note that while the cost of expansion will be recovered at some point in the future, the costs of expansion are payable now.

It’s at this time of year that a company should be considering factoring. The cost of factoring will be offset by the additional revenue generated by their expansion plan. For example, if a business concludes that an expansion of its sales and marketing staff will generate more revenue in the coming 6 months, they could factor the revenue during those 6 months in order to have the cash resources to grow beyond that period.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The Cost Of Extending Credit

When a business extends credit to its customer, the business effectively becomes their banker. This is because the business has lent money to the customer, free of interest for 30 days or more. In the meantime, the business has lost the use of that cash, while hoping that it will be paid.

Extending credit on a regular basis affects a business in 3 ways

1. The business loses interest income that it could have earned – even in a low interest savings account.

2. The business may not have enough liquid funds to pay for volume discounts or early payment discounts from its suppliers.

3. The business may lack the working capital to begin the next job or project and thereby risk losing potentially profitable business from creditworthy customers.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring & Inventory Financing

For the avoidance of doubt, they are completely different.

Factoring requires the completed delivery of goods or services, for which an invoice has been issued, awaiting payment. The invoice is sold at a discount to a Factoring company in return for an initial cash advance.

Since Factoring is the sale of an invoice, it is not a loan. It allows a company to grow debt-free.

Inventory Financing is a line of credit secured by physical inventory. It makes the cash tied up in your Inventory available to you. It is a LOAN and therefore repayable – It is a Lender / Borrower arrangement.

It is usually available to businesses with good credit and sales history. By contrast, Factoring focuses on the credit worthiness of the debtors of the business i.e. the customers who are responsible to pay the invoice.

When Is Inventory Financing Available?

1. When you have a warehouse of goods ready to ship, but find yourself short of cash to buy supplies for your next production cycle;

2. When you have to maintain high levels of inventory to conduct ongoing business that keeps too much of your cash tied up.

3. When you have good turnover in your inventory, but are short on cash flow and you have to keep replenishing your stock.


When Is Inventory Financing Not Advisable?

When you have a storeroom full of out of date or hard to sell merchandise. It will add interest charges and will make a bad situation worse.


Potential Problems With Inventory Financing

1. High interest rates or other fees.

2. You may have to pay off the Line of Credit every 12 months – regardless of the state of your Inventory.

3. If sales slow down, you may have to unload your Inventory at a loss, undermining your ability to stay current on your line of credit.

4. The interest on the loan may sap your ability to keep production or shipment on schedule.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

9 More Reasons To Factor

1. Meet Payroll and Payroll taxes.

2. Pay off outstanding debt.

3. Service existing debt promptly and improve the business credit rating.

4. Fund new Marketing strategies.

5. Fund new E-commerce strategies.

6. Increase available cash on the Balance Sheet while reducing the amount of Accounts Receivables.

7. Reduce or eliminate the need for outside investment in the company

8. Makes the company more attractive to outside investment because of guaranteed cash flow.

9. Factoring operates as a stand-along product, or, it can work alongside traditional bank finance or venture capital or loans from Small Business Organizations.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring And Outsourcing

Much has been written about Outsourcing and the apparently detrimental effect it is having on the workforce. Regrettably, we are being conditioned to automatically assume that Outsourcing means having your skills exported halfway around the world where your job can be done for a fraction of your salary.

In Factoring, when the invoices are sold, the Factor becomes the company’s Receivables Management arm. If a company always has its eye on the bottom line, the hard truth is that chasing up on unpaid invoices is neither efficient in terms of cost or time.

The reality is that the company has to focus on Sales, Marketing and Production.

Therefore, Factoring effectively allows a company to outsource non-productive work, without attrition or loss of critical people skills and guaranteeing themselves a steady cash flow, without additional debt.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Telling The Customer

For starters, Factoring is not new. It’s been around for several hundred years and that in itself is a surprise – particularly to small and mid-sized companies who habitually look for traditional financing via a bank. Large and very well known publicly listed companies factor all the time.

The business has decided to rationalize its cash flow in order to guarantee future expansion. The fact that you are not using a traditional bank, but private financing, shows that the company is financially attractive. It therefore has a range of financing options.

The customer’s payment terms will not change.

The customer will still have the routine contact with the business and its personnel. Nothing will change there.

All the business invoices to the customer will come via the Factoring company, with a written instruction that the customer is to make full payment on that invoice direct to the Factoring company.

The Factoring company is not a collection agency, but they will be providing real time online status of unpaid and paid invoices to the business. This will allow the business to objectively monitor its cash flow from all or any of its customers.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

14 Reasons To Factor

1. Leverage your customers credit.

2. Factoring is faster than a bank loan. The documentation is straightforward

3. Factoring company acts as your Receivables Management company, providing real time status of your outstanding invoices. They will be in charge of collections.

4. The Business can concentrate on Sales and Marketing instead of chasing up unpaid invoices.

5. Factoring companies will do credit checks on your customers and warn you of potentially high risk customers.

6. Faster incoming cash flow to meet overheads plus capital investments either by way of outright purchase or equipment leasing. If leasing, then guaranteed cash flow will help the business calculate lease payments.

7. The business can choose which invoices to factor, how much they want in factored funds and for how long. Alternatively they can factor all invoices indefinitely.

8. Increased cash flow means the business can take advantage of early payment discounts from its suppliers.

9. The Business can stop offering early payment discounts to its customers. In practice, customers who have more time to pay, buy more goods and services more frequently.

10. Faster incoming cash flow means a business can build or repair its credit and service debt more confidently.

11. Accounts Receivables become an immediate liquid asset, instead of a contingent asset on the Balance Sheet.

12. Factoring reduces the amount of Bad Debt which appears on the Balance Sheet.

13. Since Factoring is the sale of invoices for cash, no new debt is incurred.

14. No need for the business to surrender equity.

© 2007 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Types Of Factoring

When a factoring company decides to buy the invoices from their client, the factoring contract will state whether the funds supplied are on a Non-Recourse or Recourse basis.

What’s the difference?

Non-Recourse
In buying the invoices from the client, the factoring company assumes the full risk that the payor of the invoice will not pay them in full or at all. To cover themselves against this risk, factoring companies carry credit insurance. That’s why factoring companies are so interested in the creditworthiness of the ultimate payor.

Recourse
Sometimes referred to as Full Recourse. After a certain period of time, usually 90 days after the invoice was due for payment, the client will have to owe the advance back to the factoring company. In practice, the factor may set-off this amount against an advance on a later invoice which the client offers for factoring.

© 2006 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Focusing On The Best Clients

A business that is seriously considering Factoring as an important part of its cash flow strategy, needs to focus on 2 things:

Acquiring good clients – i.e. clients who pay invoices promptly, preferably within 30 days. The more creditworthy the payor, the better the discount rate the funding source will quote. It is important to remember that a funding source does its own creditworthiness check on the payor BEFORE agreeing to factor. They can therefore assist their clients in identifying potentially problem payors. This is an important service that a business client does not get from a bank.

Selling consistently to those clients - Why? Once the funding source sees a pattern of prompt payment on the factored invoices by the payor, the client may receive a better Advance rate and in due course, a better discount rate.

© 2006 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The 3 Parts Of Factored Funds

The previous post alluded to the 3 parts of factored funds:

"Having purchased the Receivables, the funding source will initially advance 75% - 90% of the invoice amount up front and will pay the remaining amount – minus a service fee – after the Client’s Debtor pays the full value of the invoice to the funding source. The service fee is expressed as a discount from the face value of the invoice. The discount varies according to the length of time the invoice has remained outstanding."

Advance
This is the dollar amount the funding source will fund initially. It is always expressed as a percentage of the face value of the invoice

Example: if an invoice of $100,000 is being factored and the funding source says it will advance 90%, the client will receive an initial funding of $90,000.

Reserve
This is the dollar amount held back until the ultimate debtor pays the funding source. Once it is paid, the funding source releases the Reserve to the client (minus the service fee i.e. the discount)

Factoring companies have differing policies and time lines as to when the Reserve will be released to the client. Some funding sources like to keep a semi-permanent Reserve as partial security for the risk they are incurring in factoring.

Discount
This is the service fee for funding the invoice and is expressed as a discount from the face value of the invoice. The discount varies according to the length of time the invoice has remained outstanding.

Example: 2% 30 days

Obviously, the longer the invoice has remained outstanding, the higher the discount from its face value since the risk of the factor not being paid by the ultimate debtor, increases. That’s why it’s usually a good idea for a business to factor the invoices of its best clients i.e. its fastest paying clients, first. They will receive a lower discount rate on those invoices whilst increasing their cash flow.

© 2006 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Factoring 101

Where a business has already supplied goods and services to another business (not an individual consumer), it can sell the Invoice to a 3rd party for immediate cash at a discounted value, rather than waiting for its customer to pay up. Factoring is the sale of commercial paper. The 3rd party, having bought the Invoices from the business, now assumes the risk of obtaining payment from the customer.

The company that BUYS the invoices is the Factor (or funding source). The company that SELLS its invoices (also known as Accounts Receivables) is the Client. The company to whom the invoice was addressed, and which remains liable to pay the Client’s invoice, is the DEBTOR.

Having purchased the Receivables, the funding source will initially advance 75% - 90% of the invoice amount up front and will pay the remaining amount – minus a service fee – after the Client’s Debtor pays the full value of the invoice to the funding source. The service fee is expressed as a discount from the face value of the invoice. The discount varies according to the length of time the invoice has remained outstanding.

Factoring is NOT a loan. The Client sells its invoices to the Factor at a discounted amount in return for virtually immediate capital. There is no need for the Client to wait 30, 60, 90, 120 days or longer for its debtors to pay its invoices, or run the risk of declaring them as Bad Debts. In other words, the business that sold the invoices for cash, capitalized on the time value of money.

When a bank extends a line of credit, it means that the company is, or soon will be in debt. In private Factoring, there is no loan and there is no debt. The amount of money available pursuant to a sale of the invoices is based not on the creditworthiness of the company – but of its customers. As the company sells to creditworthy customers, more money is made available and the business can grow exponentially – debt free.

When deciding to factor, the funding source is more interested in the creditworthiness of the Debtor i.e. the payor of the Invoice, because the funding source, in buying the Invoice from the Client, will look to the Debtor for payment.

© 2006 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

Commercial Invoices & Factoring

Factoring is all about the funding source buying the commercial invoice. In other words, the funding source buys commercial paper.

A company seeking Factoring legally assigns the invoices to the Factor. Depending on the financing needs, the company may assign, from a specific date, all invoices as they arise or, it may simply choose to factor certain invoices over a set time period to get them over a cash flow hump.

© 2006 Sanjeev Aaron Williams & Cashwerks All Rights Reserved

The Commercial Invoice

It's an essential document that evidences the sale of goods or services in a B2B transaction. Yet, it's often taken for granted and not properly scrutinized.

Since Factoring is all about the funding source (the Factor) buying the commercial invoice, herewith is a summary of the important features of an invoice in order for it to qualify for Factoring:

1. Value Of The Invoice - This must be clear and unambiguous. Rarely is there any problem in determining how much the debtor owes to the vendor.

The invoice will usually itemize the quantity of the product of length of time the services were provided. This will be done by a unit price and a total price for the product or service delivery.

2. Payment Terms - The invoice must have the payment terms clearly stated on its face. To be factorable, the invoice must be payable in full and must be in respect of a completed supply of goods or services.

The Factor has to be pretty sure that the debtor will pay within that time frame. Otherwise, factoring fees and discount rates may be affected. The longer the debtor takes to pay, the greater the risk of default - and the greater the risk to the Factor buying that invoice.

3. Verification - The invoice will have the name and contact details of the debtor required to pay it. When it is submitted to the Factor for funding, the Factor will always verify the authenticity of the invoice to confirm that the debtor will no make any set-off, charge-back or adjustments to the invoice amount.

© 2006 Sanjeev Aaron Williams & Cashwerks All Rights Reserved