The factors' assessment of a prospective client

It is usual for a factor, in giving consideration to the acceptance of a prospective client for the full services and the terms of the proposed arrangement to make four distinct assessments :

The risks arising from the service of protection against bad debts.

The administrative burden to be borne by reason of the service element of the arrangement.

The strength, profitability and prospects of the business of the prospective client and the use to which the factoring service will be put.

The factor's security - the extent of the risk that the debts purchased may become irrecoverable otherwise than by reason of the insolvency of the debtors.

In order to make an assessment of all these features a factor should first make enquiries for basic credit information on the prospective client ; this usually comprises the sight of audited accounts, a search at the Companies Registry (if a corporate body), a status report and in particular in the case of a recently established business, enquiries regarding the previous business activities of the principals. In addition to these enquiries a full investigation of the activities of the business and its accounting records is usually made by members of the factor's staff. The investigation which is often referred to as a 'survey' is normally completed in a day by two people. The principal matters examined are described in the succeeding paragraphs.

The nature of the business

The ability of the factor to recover debts purchased depends very largely upon the product of the business, its acceptability by the customers and the usage's and customs of the trade. The consideration of this aspect is important, not only as regards the factor's security, but also in relation to credit risks. The more attractive and important the product is to the customer, the nearer he will conform to the terms of payment. For example, a manufacturer will pay promptly for a special material which is not available elsewhere in order to keep continuity of supply. He may well delay payment of an individual item of printed advertising material which may be available next time through a number of other sources. In chapter 5 a number of businesses were described which were likely to be unsuitable for factoring and the factor will need to consider each business individually in the light of the imagined attitude of the customers in the absence of the client to provide back-up. No definite rules can be prescribed because, even within the same trade or industry, the products vary considerably. It seems that the best guidelines are:

• The nearer that a product is to being 'made, sold and forgotten,' the better will be the factor's security, and,
• The more competition there is in the trade or industry the greater will be the credit risks.

These are indeed very broad guidelines for there are many exceptions. In particular in a very competitive industry the prospective client's product may be of such high quality that it is in demand by those of the highest standing. Naturally, the acceptability of the product and the type of business are germane to the prospects of success of the business.

The Terms and Conditions of Sale

For his relationship with the debtors the factor must rely on the client's terms and conditions of sale. His right to recover the debts purchased is no better than provided for in the contractual relationship between the client and the debtors. The factor should examine carefully the provisions for payment, for the debtors' countervailing rights and for reservation of title where this is included. Where orders are taken by the prospective client for delivery of goods or the provision of services over a period of more than a month the question of a "cut off" clause should be considered. The factor may have to require some changes in the standard terms before the start of factoring. The examination should also determine whether any quantity discounts are given by the client. In some cases, in which the prospective client is selling to large and powerful customers, he may be obliged to sell on the basis of the customers' standard purchase contracts. In such a case the factor should examine the terms of the most important customers and in some cases may require the prospective client to seek waivers of certain provisions; for example, some set-off provisions wider than those arising in equity or by statute or prohibitions of the assignment of debts.

The financial position of the business

It is probable that before the survey the factor will already have examined audited accounts of the business for its last completed and previous two or three financial years. However, such accounts may not give an absolute indication of the up to date position and prospects of the business. There are some in the factoring industry who consider that a factor in his consideration of a new client, should not be too concerned with this aspect; their view if that, if the factor's rights to collectable debts owing by creditworthy debtors are secure, the failure of the client will not be the cause of the loss. It is therefore sometimes considered that the detailed investigation of the viability of the business of a prospective client will cause them to miss a great deal of new business which will not be outweighed by the saving of the additional expense of a fast turnover of clients. The general view, however, is that:

• The acceptance of businesses that are likely to fail increases the factor's expenses, by reason of the cost of setting up new sales ledgers and the recovery of the debts on old ones.
• Such increases in costs may be reflected in the charges of the factor to all clients.
• Such an attitude tends to lend credence to the allegations that a factor is a relatively expensive financier of last resort.

As a result most factors consider that an examination of the up-to-date financial position of the prospective client, his prospects, the viability of the business and the benefits which will accrue to it from the use of factoring is of the highest importance. For this purpose, apart from financial accounts, the examinations will often include :

• Up to date management accounts
• An analysis of trade creditors by age
• The checking that amounts payable for PAYE, VAT and National Insurance have been settled satisfactorily
• A consideration of cash flow forecasts
• Administration of sales records by client

Invoicing procedure

It is important for the factor to ensure that order/invoice cycle in the client's system is such that the invoices will represent only goods despatched in the United Kingdom to customers or services completed. It is also important for the factor to ensure that documents proving delivery or the completion of services, such as delivery notes or signed time sheets, will be readily available for him.

Sales ledger and source documents

An analysis of the ledger and invoices and credit notes over a period of one year should reveal the workload to be accepted by the factor. The following are normally extracted:

• the average value of individual invoices issued ;
• the number of credit notes issued;
• the proportion of credit notes issued by value to total gross;
• the average number of remittances, received each month and, in particular; the number that my be automatically appropriated to specific invoices ;
• the incidence of settlement discounts;
• the number of active debtor accounts;
• the number of new accounts opened or dormant accounts revived each month.

The percentage of credit notes, the incidence of discounts and the dispute ratio will also be most relevant to the factor's consideration of his security and the credit risk. Disputes and requests for credit notes very often serve to delay collection. For the purpose of determining the incidence of disputes and queries, customers' correspondence files should be scrutinised.

Assessment of Credit Risks

The quality and spread of debtors

Unless the number of debtors is unusually small, it is not normally possible or commercially acceptable to make a detailed investigation of all the debtors at the stage when a survey is conducted. To check the credit standing of several hundred debtors is expensive staff time and in the cost of information. At this stage, therefore, the factor will obtain an indication of the general quality of the debtors by examining :

• the quality of the largest 12 or 20 regular customers and
• the incidence of the placing of accounts for collection with a debt collection agency or solicitor; and
• the average period of credit taken by the debtors (usually referred to by factors as the 'debt turn' over a period of at least one year and the comparison of this with the debt turn normally expected in the particular trade or industry.

The debt turn

The debt turn - the average period of credit taken by debtors - may also be an indication of acceptability or otherwise of the product. It may however, be the result of the absence of good collection procedures by the prospective client - the very reason for his seeking the assistance of a factor. An allegation that a poor debt turn is the result of the lack of diligence should not be accepted by the factor at face value ; a careful investigation may reveal some serious disputes, poor credit risks or even special arrangements such as consignment sales or long credit terms. The calculation of the debt turn may be carried out in a number of ways ; but the most usual is to compare the average of month end totals of debts outstanding with the gross sales value.

 AD x 365  =  Debt turn in days --------    S

Where AD = average total debts at each month end over one year and S = gross sales value for the year.

The calculation can however, conceal distortions caused by the inclusion of :

• large disputed accounts;
• bad debts which have not been written off;
• accounts on which special terms have been agreed; or
• associated company current accounts.

If possible these distortions should be eliminated by excluding such accounts from the sales value and the totals of debts. The calculation may also be somewhat distorted by any delay in the issue of credit notes. In spite of the drawbacks of this method of calculation, it has the advantage of simplicity. It may not give a true absolute figure owing to the taking of the average of outstanding debts on the basis of end of month figures, as in many cases these are regularly the highest each month ; if terms are monthly account, payments usually come in early in the second month after invoice date. It does however give a reasonable though crude indication of a trend and a comparison with others in the same type of business. by other methods the details are more difficult to extract and may also be distorted by special circumstances.

Encumbrances on the debt

A search of the Companies Registry in the case of a corporate prospective client will reveal any charge, that is subject to registration under Section 95 of the Companies Act 1948, unless it was created within 21 days prior to the search. However, as has been indicated previously, there may be a number of encumbrances affecting book debts which would not be revealed on a search. First, as regards recent charges, it is advisable for the factor to search again about four to six weeks after the start of factoring to see if a charge has been given just after the factoring agreement has been executed. It may then be a little late but it is better that arrangements should then be made with the charge for a waiver than some months later when the client may be relying more heavily on the finance provided.

Examination of Statutory Books

An examination of the register of changes and minute book at the company's registered office at the time of the survey should also be made. This may well reveal the existence of a recent charge or some other encumbrance, whether or not it is registerable. Enquiries should also be made regarding imports or other supplies on letter of credit terms for the possibility of provisions whereby proceeds of sale by the prospective client are to be held in trust for a bank or confirming house (see 16.11).

Suppliers' Terms of Business

A thorough examination of suppliers terms of sale should reveal any rights of suppliers to the proceeds of the resale of their supplies by the prospective client. A comparison of the sales ledger with the purchase ledger may reveal the possible incidence of set off available to debtors. Such encumbrances may be dealt with by waivers of their rights by the suppliers or the debtors concerned ; but a high degree of incidence of such rights of availability of set-off may call for a constant monitoring of the business by the factor. in particular in some trades and industries sales to a concern's own suppliers may be endemic. In such a case many debtor accounts will need to be excluded, because the client cannot warrant that they are free from encumbrance. This and the degree of monitoring by the factor that is necessary may make the prospect unattractive.

Finally an assessment should be made of the proportion of sales to government departments. The resulting debts are subject to possible set off by the Crown not only for contractual debts owed by the concern to any department of the Crown but also to statutory indebtedness such as that for PAYE . Again unless a waiver of this right can be obtained, it may not, in the present state of the law, be possible safely to provide factoring with prepayments to a business which sells extensively to the government.

Special Sales

The following debts are normally excluded from any factoring arrangement.

Debts owing by subsidiary, parent or fellow subsidiary companies or any business under common control with the client. It is not reasonable to expect a factor to relieve a client of the credit risk of his own associate and the provision of finance in respect of any such debt, in reality, provides no independent possibility of recovery.

Debts arising from consignment sales or sale or return transactions. If accepted at the delivery stage such a potential debt gives the factor no specific due date for recovery ; and if the debt is to be transferred only when the goods have been accepted and a firm sale completed, monitoring of the arrangements by the factor is difficult.

Debts arising from sales to individuals. Factoring is not designed for the retail trade.

Invoices representing charges for moulds and tooling retained by the client for production purposes are sometimes excluded. They should certainly not be eligible for prepayments until there is evidence that production from their use is acceptable to the debtor. Moulds and tooling that have been paid for can also create difficulties in the collection of other invoices on the insolvency of the client if the administrator of the client's estate will not release them immediately upon request by the debtor. These difficulties may arise notwithstanding that, in insolvency, there is no set off of a claim for the return of goods in specie against a claim for payment of money. Thus, the survey should reveal the extent of such special sales.

Special consideration of credit risks

Unlike a banker or other lender who seeks to reduce his risk to the minimum by taking security in addition to a thorough examination of the borrower's viability, a factor seeks the unsecured credit risks arising from trade sales. Like an insurance company, in respect of the credit protection service, the factor can only find business where the risks exists; but he must ensure that the risks are reasonable and not unduly concentrated. He must also be sure that he is properly remunerated for taking the risks in that the credit protection element (CPE) in his administration charge is adequate. In accepting these risks in return for the receipt of a fraction of 1% of sales the factor expects the balance and pattern of the sales of the business to be such that the debtors run through the whole spectrum of quality, with the largest debtors being in the main well known companies of high credit-standing. For the factor will probably be expected to accept a number of smaller debtors whose credit-standing cannot easily be assessed ; and the odds on failure of some of these smaller debtors may not be more that even money. If all the debtors are likely to be in the bottom end of the spectrum a proper assessment of the CPE may make the acceptance of the credit risk by the factor much too expensive for the prospective client. In such a case, where the gross profit margin of the business is likely to be high, it may be reasonable for the client to accept the credit risk himself. From the factor's point of view, provided that the retention were to be high factor's point of view, provided that the retention were to be high enough to provide for the high level of potential recourse, it is probable that recourse factoring or invoice discounting might be provided.

As described above, some indication of the quality of the debts is available from a consideration, during the survey, of the largest debtors and an examination of the debt turn and of accounts put out of hand for collection. In addition, records of bad debts and their relationship to sales turnover should be obtained for at least three past years. If credit insurance has been used it must be noted that the accounts will show only the uninsured percentage written off. It is important that the records should also show the pattern of such losses. Many small losses may indicate that bad debts are endemic; a few larger losses may be due to special circumstances. Details should also be obtained of potential losses within the current outstanding debts and of accounts still in the hands of debt collectors or solicitors. Enquiry should be made as to whether credit insurance is or has been provided in the past and if not whether a proposal is being made as an alternative to factoring. The terms on which credit insurance has been provided or offered, if disclosed, will be helpful to the factor in his assessment of this element of the service. It should not be overlooked that the incidence of the bad debts is also relevant to the administrative costs of the prospective factoring arrangement where the cost of legal proceedings on approved accounts is to be absorbed by the factor.

The foregoing matters are those usually examined by a factor where the full service is proposed. It may seem that for some of the variations of the service not all of these aspects require consideration. However, although there might be a differing emphasis for some of the variations it is considered that all aspects should be taken into account in relation to any form of the service. For example, it may be asked 'why consider the workload of the sales ledger where invoice discounting is proposed? In this case the answer is that the factor may have to take over to administer it efficiently. The credit risk is relevant to recourse factoring in considering the potential recourse element. In the case of maturity factoring, encumbrances on the debts may hinder the provision of a good service and create a conflict in the collection of salvage after the factor has paid on maturity in respect of an uncollected debt.

In periodic visits to the client's place of business members of the factor's staff usually monitor the continuing efficiency of the client's administration - particularly in relation to the production of source documents and the continuing profitability of the business. The frequency of such visits and the items to which attention is paid depend upon the factor's assessment of the client from his experience of his own office. For example, this will depend to some extent on the incidence of disputes, where the client continues to maintain the sales ledger, as in invoice discounting, such visits are made regularly by some factors and the items examined extend to the sales ledger and credit control. Note that a Checklist for the factor is provided in Appendix III.

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