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I Hate My Banker

by: Ryan D. Tennyson and Bradley C. Kuhn
from: The Journal of Lending & Credit Risk Management, November 1997

Factoring: A method for companies to convert accounts receivable to cash by selling them to a factoring company (a “factor”). Typically the company sells the receivables outright. But factors these days offer services ranging from classic factoring to flexible loan programs.

A growing business may outgrow its bank. That’s no slight to the banker. It’s just a fact of life. A good banker knows the bank’s limitations and will work to preserve at least part of the relationship. That’s what banker Fran Mitchell did when bank examiners balked at a loan to one of her best customers. Thinking fast, she came up with a solution that served both the customer and the bank. By putting her customer’s needs first, she turned a bad situation around to the benefit of her borrower and her bank.

Fran Mitchell’s firm handshake and jovial greeting belied her indigestion. Her lunch appointment, Bobby Marlin, could tell she was agitated, but didn’t press the issue. Marlin’s company, Family Electric, was one of Mitchell’s biggest customers. She needed both hands to count all the valuable customers Marlin had referred to Valley Bank. What Mitchell had to say wouldn’t be easy. Well, out with it, she thought to herself.

“Bobby, I can’t loan you any more money.” It was so unexpected, Marlin made her repeat it.

“Nonsense,” he said. “I give you a financial statement every month. You get a monthly list of my accounts receivable and inventory. I have put up everything I own as collateral, including my house. My company is growing. It’s making money. I’ve never missed a payment. Are you nuts?”

Family Electric was a successful wholesaler of electrical supplies. The company was best known to the public for its showroom, where it sold appliances and light fixtures. But most of the company’s sales came from the wholesale operation. Its customer base was comprised primarily of smaller contractors in commercial construction. The company sold everything from utility lines to airport lighting. These customers usually bought on credit, and paid their bills monthly.

As the company grew, so did its inventory needs. To get cash, Marlin borrowed against accounts receivable. Valley Bank had been eager to provide that credit. Until now.

“So what’s the problem?” said Marlin. “I can’t be even close to your legal lending limit.”

Mitchell found her predicament difficult to explain. Last week, in a routine examination of the bank’s loans, regulators tagged the Family Electric loan as “substandard.” It had nothing to do with the company. Valley Bank just wasn’t prepared to keep tabs on such a large inventory loan. “Oh, there’s still some room left from a legal lending standpoint,” the banker said. “The problem is that we aren’t properly dealing with the mechanics of taking inventory and accounts receivable as collateral.” Marlin was perplexed. He had given the bank a security interest in all of the inventory and the accounts receivable. The bank had filed the required notices with the county and state. What else could they possibly do?

“Lenders have to be especially careful with inventory and accounts receivable,” Mitchell explained. “A properly managed inventory and receivables loan would have a lot more controls than we currently utilize on your credit line.”

Specifically, she explained, regulators wanted the bank to make unannounced inventory inspections and collect receivables directly from Family Electric’s customers. That’s a normal arrangement. The classic revolving credit line generally involves borrowing and repaying daily. Customer repayments constantly lower the amount owed on the loan and new receivables provide additional collateral to borrow against as the company grows. This constant cycle of borrowing and repayment is why they call it a “revolving” credit line.

“That’s ridiculous! That kind of paperwork would drive you crazy,” Marlin said. “Why can’t I handle my own money?”

Under the bank’s current arrangement with Family Electric, the company handled its own collections, and made monthly payments to Valley Bank.

“Bobby, I know it’s not your style. But look at it from their point of view. The way we’ve got it set up, you could collect from your customers for a month, run up your credit line, and take off to Mexico with your secretary.”

“I see your point,” Marlin said. “I couldn’t sell my house without paying you because you have a mortgage recorded at the courthouse. But when I collect accounts receivable, I could pocket the money and disappear. But man, what you’re describing sounds like a pain in the neck.

“Well I don’t like it very much, but if that’s what we have to do, let’s do it,” Marlin said. “My customers have some large contracts coming up and I’m going to need a credit line increase in the next 60 to 90 days.”

Mitchell shook her head. “I’m sorry Bobby. I can’t increase a credit line that the regulators have already taken exception to.”

“Look Fran, I’ve done everything the bank has asked me to in the past and I will continue to do so. I think it” a giant pain in the butt, and I don” understand it very well, but if I have to do more, let” do it. Just give me the forms and tell me what to do.”

Fran did not immediately respond. She picked at her salad and took a sip of her iced tea.

“That’s what I’ve been trying to tell you Bobby. Our little bank just isn’t equipped to do all the things that the regulators want. My staff can’t monitor your loan the way we should. There’s no one on staff who would know a transformer from a television. I’ve never done one of these loans and neither has the bank’s lawyer.

“Bobby, here’s the deal. My boss tells me that if I lose your account, I’ll lose my head. My examiners tell me I can’t loan you any more money. I know you need the money. Let me see what I can do.”

This story has a happy ending. Mitchell realized that Valley Bank was not prepared for an inventory/accounts receivable loans, so she turned to someone who was: a commercial factor.

Although many business owners blanche at the thought of factoring because it tends to be expensive, Mitchell was able to get her customer a good deal.

In addition to Family Electric’s good credit record, Mitchell threw in some free banking services and a small irrevocable letter of credit, allowing her customer to cut his costs even further.

The next lunch went much better. Mitchell reported that she had arranged through a factoring company for a credit line three times as big as the one Family Electric had at Valley Bank. The cash advance formula under the new loan would be much more generous than the bank had allowed.

Customers would make payments to a lockbox at the bank, to be forwarded to the factor. But Marlin would be able to monitor the whole process by computer.

“This isn’t factoring in the classic sense,” Mitchell said. “You won’t be selling your receivables. They’re only serving as collateral. You’ll actually sign a note and be liable for repayment.”

Marlin was skeptical. Despite the bank’s efforts to keep his costs down, the factor wanted an interest rate of prime plus five percentage points. That was much higher than the prime plus one percentage point Family Electric had been paying at Valley Bank.

“Now Bobby, don’t have a coronary. With this new line you will pay down your borrowings every day, not just monthly like you do now. That will help you keep your average balance much lower than you do now. So even though your rate is higher, your actual interest costs will probably come down.

“I took the liberty of scheduling an appointment. The factor people said they’d like to come out tomorrow to look at your operation and they claim we can close in two weeks. All we need is your permission to move forward.”

Marlin had looked at factoring before. And he hadn’t been able to get even close to the terms Mitchell had negotiated. He also knew that the clumsy arrangement he had with the bank forced him to carry an average checking account balance of $100,000. The factoring arrangement would allow him to reduce that to almost nothing.

The real selling point, however, was that the available credit would grow with the business, with automatic increases as more receivables were added to the books. The change also would free up the company’s bank credit lines for additional equipment or building expansion.

“All in all, Fran, I’d say you get an A+. I’ll buy lunch.”

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Too often, commercial factoring companies are looked on as lenders of last resort. Actually, factors — from the Greek word “factare,” which means to make or to do” — help businesses make and do more by providing liquidity.

Factors are good at what they do. They have the staff and procedures required to handle the complex chores of monitoring inventories and receivables that are in a constant state of flux. This expertise allows them to safely make loans that many banks simply cannot handle.

Bobby Marlin was lucky to find a banker willing to give something away to keep a customer for the long term. Most bankers are averse to sending their customers to any competing lender.

It’s not always easy to do what’s right.