Factoring receivables refers to a transaction where a commercial business sells its accounts receivables (debtors) to a factoring firm at a price discounted from their book value and to be settled immediately. The main benefit for the business is that it gets paid the cash price immediately, improving cash flow. Second, it does not carry the risk of debtor default. Of course, the cost the business pays for these benefits is that it is paid only a factor, or fraction, of its debtor book value.
To take an example, a business has a debtor balance of $10,000 with a credit period of 30 days on a time weighted basis. That business might be offered $9,000 for those debtors by a debtors factoring firm, reflecting a 0.9 factor. If the business accepts, the debtors become the property of the debtors firm and it then has the burden of collecting the $10,000 from the debtors.
In this example, the $1,000 gap between the $10,000 book value and the $9,000 price paid for that book value represents the discount accepted by the business for its receivables asset. The size of this discount covers the risk of non-payment or default by debtor customers, time value (cost) of funds and the profit of the factoring firm.
Default by debtors is a cost incurred by the factoring firm. If it experiences an 8% non-payment rate it collects $9,200, not $10,000, from debtors over the credit period. Allowing for this default cost, the gross profit earned by the firm is $200 divided by $9,000 equals 2.2 percent monthly (30.2 percent yearly compound).
The time cost of funds relates to the opportunity cost borne by the factoring firm by foregoing the opportunity to earn a return from a risk-free investment. By using $9,000 to acquire the debtors, the firm loses the opportunity to invest $9,000 in the money market in a risk-free account based on government notes. If the interest rate applying on that money market account is 0.5 percent monthly (6.2 percent yearly), the firm loses the opportunity to generate a worry-free return of $45.
The factoring firm has effectively traded a $45 risk-free profit for a profit that has risk. As it happened, this risky profit turned out to be $200. In other words, by forsaking $45 the firm has earned an incremental $200 – $45 = $155 profit. This incremental profit is the reward for bearing the risk of non-payment by debtors. It calculates to $155 / $9,000 = 1.72 percent monthly or 22.7 percent yearly.
To earn this incremental 22.7 percent yearly profit, the factoring firm has to accept the risk of an infinite number of possible outcomes, especially losses. For example, if the non-payment rate by debtors had of been, say, 12 percent rather than 8 percent, then the firm would collect only $8,800 at the end of the 30 days and incur a loss of $200 instead of a worry-free profit of $45.