Notes from a Credit Analyst: Analyzing Credit in the Factoring World

NOTE: Originally posted as "Credit Professionals in the Factoring World" in Business Credit Magazine, January 2019 edition.

In any industry or business type, credit is a crucial aspect to the success of the company. Acknowledging the risk accessed and likelihood of payment from your customers helps promote the growth of your business by maintaining positive cash flow and security of your company’s most important asset: accounts receivable. In the normal operating cycle, the turnover of cash is measured by the production of goods/services rendered, the time it takes to sell the goods or services and the inflow of cash from the customers.

As credit professionals, we must limit the time cash is outstanding, but simultaneously remain competitive and justified with requested terms and set limits. Every business faces this challenge, but an additional layer of complexity is introduced when the credit professional is managing accounts for a factoring business.

What is factoring?

Factoring is a financial transaction where the “factor” purchases either all or part of another company’s book of receivables for an agreed term based on a discounted rate. This form of financing allows the client company, or seller of the receivables, to receive an immediate influx of cash to avoid waiting for payment from the account debtor, which can extend up to 120 days dependent on set terms. The three parties directly involved in a factoring transaction are the factor (purchaser of the receivable), the factor’s client (seller of the receivable) and the account debtor (the business that becomes financially liable to the owner of the invoice).

This type of financing is secured by filing a blanket UCC1 on the seller‘s company which grants the rights of the assets to the factor. It then becomes the factor’s responsibility to extend credit and collect on the outstanding receivables purchased. Many different types of businesses around the globe use this type of financing to support the success and growth of their business.

Challenges for a credit professional in factoring

The immediate difficulty faced by a credit professional working for a factoring company
is the lack of initial contact with the account debtor. This poses an increased risk instantly since nobody working within the factoring company has developed a relationship with the account debtor and cannot judge that entity’s character. This is an essential “C” within the Five Cs of credit since it measures the integrity of the business which is now financially responsible for the payment. The credit professional needs to feel comfortable with their client’s (seller’s) ability to judge this element. This is achieved by the factor’s underwriting team which performs due diligence on the client as well as the account debtors before establishing the account. The character of the factor’s client is judged during this underwriting process with the expectation
that the client carries over those same best practices in judging their customer’s character.

In addition, the credit professional also needs the client to provide them with complete and accurate information regarding the overview of the account debtor (legal entity name, headquarters’ address, payables contact information, trade references, etc.). This is obtained by developing a thorough credit application that the client would need to fill out and return to the factor in order to establish an appropriate credit line. The credit application is an important tool for the factor and should be referred to often in order to maintain accurate and effective collection efforts. Maintaining and updating the credit application also helps aid in the risk assessment for the factor as well as the client. Internal periodic reviews of the credit application will help closely monitor the performance of the account debtor and aid in the justification of the
extended amount of credit/terms.

Now the fun begins

Once the account debtor(s) has been approved and terms/credit limits have been established, as in all types of business, the fun part really begins for the credit professional— because who said credit cannot be fun? As many of us have experienced, just because an account debtor is creditworthy does not necessarily mean the company will pay on time, in full, or at all. Multiple variables arise causing this, such as the account debtor never receiving the invoice/proper backup, billings aren’t clear as to when they are due, product or service quality is slipping, or timely fulfillment of orders is lacking, just to name a few. These are all issues every credit
professional faces, but in the traditional model of factoring, these issues cannot be
controlled internally.

Some factors offer a program to their clientele where the seller of the accounts receivable (client) provides the factor with the necessary information in order to generate invoices. The factor could then bill the account debtor directly. This is generally referred to as full service factoring. However, in the traditional model of factoring, the responsibility of billing lies solely with the factor’s client. As you can imagine, the degree of risk is heightened and the assurance of billing accuracy becomes an ongoing concern. Losing the internal control of this function causes the credit professional to always be on high alert for fraudulent billings, accurate remittance information presented on the invoices and assurance the invoices are being sent to the appropriate companies and departments.

Managing fraud

Fraud is always in the back of every credit professional’s mind, but it can be managed
quite effectively and efficiently. One of the most important things a credit professional can do to mitigate risk is focus on how the account debtors are paying along with remittance advice generated with that payment. A factor should consider the following:

Are payments received from the expected party?
If the credit professional has underwritten XYZ Company then payments should be received directly from that entity. If payment is received from another unrelated entity, an accurate profile may not have been established for the proper account debtor.

How are the payments made?
Know if the account debtor is paying by check, EFT (ACH or wire), or credit card. Changes in the method of payment can sometimes alert the credit professional that the account debtor may be in financial distress or has misdirected/converted funds. An account debtor that has always
paid by check and then switches to EFT can certainly improve the speed and reliability of payments, but if and only if they are coming from the appropriate entity. Conversely, if the account debtor has always paid by EFT and then switches to check or credit card, the financial stability of the account debtor may be in question.

Are the payments sent directly to the factor?
Although we always want to assume positive intent by our clients, they should not be the middlemen and simply pass payments received back to the factor. Of course, this may initially happen when the change of remittance is communicated to the account debtor at the beginning of the factoring relationship, but it should not be an ongoing occurrence. (Remember sometimes desperate people do desperate things). Many factors operate using a bank lockbox to receive payments. Those checks received should be reviewed regularly to guarantee origin. Also, for EFT transactions, always revert to the first question, are the payments being received from the expected party? This is sometimes difficult to detect, but analyzing the detail of the incoming
transfer can help you trace the origin of the electronic transfer of funds.

How is the remittance advice received and is it clear and concise?
The best-case scenario is the remittance is either provided with the check, EDI (electronic document information), or emailed directly to the factor from the originator of payment. If the client handles this remittance information and passes it on to the factor, it is always possible the client may alter the information. Sometimes handwritten remittance is provided and should be verified with the account debtor unless it’s clear that payment received did come direct. Remittance advice can also read “oldest invoices” and should not be applied unless written confirmation from the account debtor is confirmed.

Ultimately, all credit professionals follow the same basic credit principles while managing
their portfolios, but each industry focuses on specific aspects that contribute
to their success. Credit in the factoring world is just one of those examples.

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(313) Kevin Elliott

About the Author
Kevin Elliott, CBA, is a senior credit analyst with Advance Partners. He has worked in the factoring industry for 13 years, including more than
nine years analyzing credit. Kevin graduated from John Carroll University in 2007 with a BA in Marketing. He went on to receive his MBA from Cleveland State University in 2009 with a concentration in Operations and Business Management.