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Written by Kent Harlan, CPA
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 The economy, which has been on a four year growth cycle, is softening. Some economists are predicting a recession in the near future. This will affect the cash flow of many companies large and small. Receivables factoring can be a valuable financial tool to help weather the storm, but consistent monitoring and performance improvements are critical to the effort.
The invoice factoring industry is expected to grow substantially as the economy continues to soften. The threat of a recession will likely increase demand for the service. The onslaught of the sub-prime mortgage crisis and the high rate of adjustable rate mortgage resets in the next two years are added variables to an already slowing economy.
Because of the predicted slowdown, invoice factoring companies face a mix of incredible opportunities and potential danger. If a recession does occur, there will likely be a shakeout in several industries. Some sectors are already getting hit hard, such as construction, property management, and building supply manufacturers. However, it often difficult to determine who else will suffer before it actually occurs. That's why it's very important for lenders of all types to upgrade its underwriting processes and structure. Of equal importance is the need to have effective monitoring systems in place to detect if a company is just going through a natural down cycle or if its very existence is threatened.
It is important for a factoring client to understand that the enhanced underwriting and performance monitoring processes are not just a way to limit the funding company's exposure. They are also valuable tools that can help the firm maximize results and even keep it from extinction.
Evaluating a company's current financial stability
In the early 1960's, Edward Altman developed a statistical model for determining a company's financial health and a predictor of bankruptcy that is still used today. Called the Altman Z-Score, it uses five financial ratios comprised of eight items from a company's financial statements. The five ratios and weighted average for each ratio in relation to the total score as follows:
Ratio Weighted Average
1. EBIT/Total Assets 3.3
2. Net Sales/Total Assets .999
3. Equity Mkt. value/Total liabilities .60
4. Working Capital/Total Assets 1.2
5. Retained Earnings/Total Assets 1.4
After inserting numbers derived from a company's balance sheet and income statement and coming up with the total, the model asserts the following:
A Score over 3: reflects a company on solid footing
Between 2.7 and 2.99: The factoring company should exercise caution and require increased monitoring.
Between 1.8 and 2.7: There is a good chance of the company going bankrupt within 2 years.
Less than 1.8: 94% chance that the company will need to file bankruptcy within the next year.
The Z score is just one tool in the underwriter's arsenal to determine if the company is a good (or poor) candidate for invoice factoring. Other fundamental methods should be used in conjunction with the Z-score such as financial trend analysis of revenues, expenses, and profits. In addition, there may be internal and external factors that could change the ratios in the future such as new product roll-outs, mergers, and new competitors in the industry.
Monitoring and assessing results
The factoring company should constantly monitor results, preferably monthly. If two or more of the ratios used in the Z-score are reflecting an adverse trend, the lender should meet with key company personnel to discuss strategies for improvement. Again, the client should understand that these aren't bullying tactics. The meetings are essential to the company's viability. If it is determined that performance improvements are unlikely to occur in the near term, the client should be referred to a turnaround specialist. These type of companies are adept at structuring a very disciplined and urgent solution.
Could your company benefit from an infusion of working capital? Click here for a free factoring quote or call us at 417-849-7394.
Click here to read our blog on Accounts Receivable Factoring.
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