Planters, Money, Factors, Risk, Interest, Discounting, Accounts Receivable and Accounts Receivable Factoring

Posted by PITHOCRATES - November 27th, 2012

History 101

When a Factor advanced their Money to a Planter it could take up to 9 Months or more to Get it Back

It takes money to make money.  And in the early days before big banks there were few places to get big amounts of money.  Which you needed in the New World to grow large crops like tobacco.  You needed big amounts of money because it took a long time from planting a crop to getting it to market in Europe.  Planters needed money to plant, grow, harvest, bale, ship to a seaport where it then shipped by sail to a European market.  Then money from the eventual sale of that tobacco would take a couple of months to make it back to the planter.

It could take up to 9 months or more before they actually got the proceeds from the crops they grew.  And there were no large banks to provide financing for the planters.  So what did they do?  Enter rich people.  And merchant banks.  Factors.  Who advanced planters money to plant, grow, harvest, bale and ship their crops to a European market.  And when they sold those crops and the money worked its way back across the ocean it went to the factors.

But why would rich people do this?  Why would they take a risk with their money?  When they advanced their money it could take up to 9 months or more before they got it back.  A lot could happen in 9 months.  A drought could have wiped out their crop.  Insect infestation could have eaten their crop.  Fire could have destroyed the crop as it made its way to an ocean going sailing ship.  And that sailing ship could have suffered damage in a storm and sank.  So there was a lot of risk these rich people took.  So why did they?

Factors bought a Future Crop at a Discount from what they Expected it would Sell For

Well, they could mitigate some of this risk by purchasing marine insurance.  To cover the cost of their cargo in the event it was lost at sea.  But insurance policies aren’t free.  They cost money, too.  Not to mention the shipping costs to get these crops to market.  Costs that had to come out of those crops.  So there are costs.  And some work.  Back then you didn’t buy insurance or pay for transportation electronically.  People went to places and negotiated these things with other people.  People who earned wages and didn’t work for free.

Today when someone borrows large sums of money they pay interest.  Which helps to offset any costs incurred.  And let’s people earn money by loaning money.  Which provides an incentive to loan money.  Which is the only way people can borrow money.  When people are willing to loan it.  And people only loan money when it’s worth their while.  People save their money in the bank to earn interest.  They don’t put it there so others can borrow it for free.  But before large banks they needed another way to get money to people who needed it.  Which brings us back to those factors.

Factors made their money by discounting.  Which is a way of earning interest without charging interest.  When you buy a Treasury bill you are acting like a factor.  You may pay $970 dollars for a Treasury bill with a face value of $1,000.  When you redeem this Treasury bill the government pays you $1,000.  Giving you a $30 financial gain.  Which works out to an effective interest rate of 3%.  People like buying treasury securities because they are backed by the full faith and credit of the United States.  So there is little risk.  Whereas factors took a huge risk.  So they didn’t do it on any promise to pay.  They got collateral.  They bought a future crop at a discount from what they expected it would sell for.  Which became theirs.  And when that crop sold they got all the proceeds from that sale.  Hopefully they got as much as they thought it would sell for.  Or more.  But, of course, they took the risk that it might have sold for less.

Accounts Receivable Factoring is a Quick and Easy Way for a Business Owner to Raise Cash

Many small businesses will struggle to grow if they don’t offer credit.  Allowing their customers to buy things on account.  And then paying for all of their monthly purchases at one time at the end of the month.  This convenience encourages repeat customers to buy more.  And it allows them to buy things that they can sell later.  Like a restaurant owner who buys food from a restaurant supplier.  After selling prepared meals in his or her restaurant customers pay them.  Which allows the restaurant owner to pay his or her restaurant supplier at the end of the month.  A system that works well.  And benefits both supplier and customer.  That is, as long as people are dining at that restaurant.

But sometimes people stop going to restaurants.  And stop buying from other businesses.  Making it difficult for these businesses to pay their bills.  So they start paying their bills slower.  Instead of paying them in full at the end of the month they may take an extra month.  Or two.  So businesses who sold things on account have a growing list of outstanding invoices.  Or accounts receivable (A/R).  They print out their A/R aging report and they slowly see their open invoices go from 30 days to 60 days to 90 days.  Leaving them short of cash to pay their own bills.  And if they already maxed out their credit line they may be unable to borrow money.  So what other option do they have?  Here’s a hint.  Most of their outstanding accounts receivable will eventually become cash.  In time.  All they need is a way to get someone else to wait for that time to pass.

What they need is a factor.  Someone to buy their accounts receivable.  Giving them the cash they need.  While the factor will then pursue the collection of those outstanding invoices.  Most of which the customers will pay.  And it’s these invoices a factor will buy at a discount.  The small business owner loses some profit but they make up for that by getting the cash they need to pay their bills.  Accounts receivable factoring is a quick and easy way for a business owner to raise cash.  For unlike a loan there is no review of a company’s assets and liabilities.  No collateral to pledge.  No financial statement analysis.  For the owner is selling an asset.  His or her accounts receivable.  Which is the only thing a factor looks at.  The quality of those receivables.  Which they converted into cash.  Giving business owners the money they need to get back to the business of making money.  Much like those planters did in colonial America.

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