The main purpose of this post is to present the topic of “factoring” with some explanation relative to investing in stocks. Factoring is a means of translating receivables into cash whereby a company sells its receivables to a factor (usually a finance company) with or without recourse. To learn more, go here.

Factoring has been around for centuries. It seems that factors are becoming more creative with factoring arrangements today. Factoring is often found among the smallest of publicly traded companies. Farming out the credit department work to another party (the factor) who will perform that function for a portion of the collected receivables plus interest may be cost effective relative to doing it “in-house.” This can especially be true for a company that believes it has solid growth prospects and needs cash today but lacks access to capital markets due to its very small size. In fact, it may be the company’s only alternative to sustain enough liquidity to pay operating costs on a timely basis.

Farming out the credit function for cost efficiencies is a weaker argument than it once was. With the current age of information access, things like credit worthiness of potential customers can be determined quickly and at little cost by even the smallest of companies. So, it is likely to be the case more often (where very small companies are involved) that factoring is utilized when working capital is tight and a growth strategy is being pursued. If that sounds aggressive, it is, and, of course, represents a substantive risk.

My Scorecard checks for adequate liquidity as one of its two quality checks on a company’s balance sheet. My adjusted current ratio (as described in my book, “Choose Stocks Wisely“) examines the working capital not only for adequacy of “amount” but also for its cash and non-cash composition.

I’ve written previously about a company’s Securities and Exchange (SEC) 10Q and 10K filings. Those filings will reveal whether a company is factoring its receivables. You may never encounter a situation where factoring is present. If you do, be aware that it may point to substantive risk with regard to the sufficiency of working capital to sustain operations or to achieve desired growth. In most cases, you would likely find that my Scorecard’s liquidity standard (adjusted current ratio) would not be satisfied.

Remember that for a company to be a good value at a cheap price, it can’t just be “cheap” price-wise. It must be financially stable enough to take advantage of future potential. My Scorecard doesn’t just attempt to score a low price; it first attempts to look for financial stability.