A factor company’s underwriting process evaluates new clients for factoring programs and takes into consideration the financial strength of the prospective client’s customer base. The financial strength of the client’s customer, or account debtor in factoring terminology, is a good indicator of the likelihood that the account debtor will pay the client’s invoices within the agreed-upon payment terms, which in turn repays the amount advanced to the client. 

Importance of Account Debtor Evaluation Criteria

It is important for factoring brokers to know the account debtor evaluation criteria that factoring companies use in underwriting. Knowing the evaluation criteria will give you a better understanding of the profile a potential client’s customer needs to have in order to meet underwriting criteria. It will also help you to avoid time wasted pursuing prospective clients that are unlikely to be approved because their customers do not meet evaluation criteria. It will give you more time to prospect for potential clients with customers that are more likely to be approved in the underwriting process.

The following are some of the criteria used to assess the current and future health of an account debtor. The weight given for each criteria may vary on a case-by-case basis depending on the circumstances.

Account Debtor Evaluation Criteria

• Financial Statements

• Key financial indicators such as profit margin, working capital ratio, and quick ratio.
• Appropriate values for assets, particularly accounts receivable and inventory.
• Reasonable cash reserves and working capital. 

• Credit Ratings 
  • Business credit reports from credit bureaus such as Dun & Bradstreet (D&B), Experian, and Ansonia provide information on credit scores, years in business, high trade credit amounts, payment history, key financial ratios, as well as litigation, lien and bankruptcy history.
• Trade References

• Payment history – A newer relationship may not be acceptable as a trade reference.
• Highest amount of credit used – Low credit amounts may not be a good indicator of the account debtor’s payment history.
• Amount owing – Large amounts may indicate slow payment, cash flow problems or over reliance on one supplier.
• Total past due – Dependent upon length of time past due, frequent and large past due amounts may jeopardize the evaluation.
• Terms of sale – Limited payment terms, deposits, or cash in advance may indicate prior payment problems.
• Date of last sale – An old reference may not be useful for an evaluation.

• Bank References

• Length of the account debtor’s relationship with their bank – A newer relationship may indicate prior financial problems at another bank.
• Type of collateral – secured or unsecured.
• Credit facilities – Facility amount, and current and high balance. Having a high balance or not being in compliance with covenants may indicate cash flow problems.
• Checking account – Current and high balance, and NSFs. Low balances and NSFs may indicate cash flow issues.

• Client’s Internal Pay History
  • Length of time the client and account debtor have been doing business.
  • Previous payment history the client has with the account debtor – High credit, total volume, average payment days, past due amount, and write-offs.
  • Concentration – A client having a large portion of its invoice volume made up by only a few account debtors may affect the approval decision. 
• Public Filings
  • Public companies are required to regularly submit public filings and financials -information may be more accessible on the internet by using websites such as YAHOO Finance or EDGAR on the SEC.gov website.
  • Things like stock performance, financials, existing lines of credit, disclosures, etc. are evaluated.
• Bond Claims – applicable for construction industry contractors

• Surety bonds – amounts and terms
• Claims against surety bonds – Claims may compromise accounts receivable eligibility for factoring.

• Web Presence

• The account debtor’s website, social media, and news articles may all contain information relevant to the underwriting process.

The following are some potential red flags that may indicate problems for an account debtor evaluation.

Potential Red Flags

• Low bank account balances – Low balances may indicate a cash flow and working capital problem.

• Lack of existing credit facility – May indicate problems obtaining credit in the past and/or insufficient investment capital.

• Limited trade references – Limited trade references may indicate past credit problems and insufficient working capital.

• Very limited operating history – Companies with a very limited operating history tend to be higher credit risks due to the increased likelihood of operating problems and the financial difficulties they create. 

• Prior bankruptcy – May indicate a risk of continuing operating and financial problems.

• Excessive litigation – More litigation than normal, and a reputation for being difficult to do business with, may increase the risk of operating and financial difficulties.

• Contra-accounts – If the prospective client and the account debtor have account payables and receivables with each other, the account debtor could offset the payment of the client’s account receivable, which would compromise the factor’s collateral.

• Affiliates and arm’s length transactions – Accounts receivable from related party transactions are usually ineligible for factoring. 

• Credit terms – If the account debtor offers extended terms, it may create an unacceptable level of financial risk.
• Consignment sales – Consignment sales distort the account debtor’s financial statements – accounts receivable, sales, and profits are overstated and inventory is understated.

Account debtor evaluations are an integral and important part of the underwriting of a new client. Understanding account debtor evaluation criteria will help you to identify prospective clients with customers that are more likely to be approved in underwriting. It will help you to focus your marketing and prospecting efforts more effectively to increase business volume.

Capstone has the experience and resources to help you build your business volume. For more information on Capstone’s broker resources, please read Broker Resources – Capstone Corporate Funding.