Invoice factoring is wrongfully considered to be a very expensive form of business financing. Not so. Used properly, factoring is no more expensive than taking payment by credit card or offering special payment terms to customers such as 2/10 Net 30.
The misunderstanding about cost stems from confusing "purchasing" with "borrowing." This is a mistake made by many bankers, accountants and business owners. As a result, they turn away from the usage of a highly efficient - and cost effective - financing tool.
Purchasing vs. Borrowing
A factoring transaction involves the sale of individual invoices as unique and distinct financial instruments. Each invoice has a face amount. Each has a distinct payee (i.e., company obligated to remit payment for product and/or service). Every factoring transaction is discrete. It involves a separate, uniquely identifiable financial instrument (invoice) purchased at an agreed upon price. That price is determined by an agreed upon discount rate.
For example, if the factoring agreement calls for a 3% discount rate, a $100,000 invoice would be purchased for $97,000. If a company factored a $100,000 invoice each month for 12 months, they would have consummated $1,200,000 in business with their customers. At a 3% discount, they will have a business expense of $36,000 and net $1,164,000.
Borrowing is different. It is similar to renting a vehicle. The rental agreement grants you the right to use the vehicle but you must return it at the end of the agreed upon period and pay for the privilege of the usage. In this case, what is being rented is money. Businesses frequently rent money in an effort to accomplish the same objective as factoring. That is, to manage cash flow. A bank will provide a certain volume of funds for a period of time at a specific interest rate. Those funds may be granted in a lump sum or through a line of credit where funds are accessed and returned, accessed and returned, etc.
If the company borrows $1,200,000 at 3% APR, at the end of 12 months they will have a business expense of $36,000. In other words, whether the company borrows $1.2 million or factors $1.2 million, their cost of money will be the same.
Where People Go Wrong
Most people do not make the distinction between purchasing and borrowing. They will look at a factoring transaction and see the 3% discount rate on a month's invoices and think: "Oh my! Three percent per month? Why that's 36% interest!"
What's occurred is the individual has attempted to change a discount purchase rate into an annual percentage rate. They are not the same. The discount rate in factoring is applied to discrete transactions. The annual percentage rate in borrowing is applied to the amount of funds borrowed. The two are not interchangeable.
A Better Comparison
At its most basic level, factoring is a means by which a business owner collects immediate payment from customers who either cannot or would rather not pay with cash.
In the world of consumer-based businesses this is done by accepting credit card payment. Here's what happens:
- A consumer uses a credit card
- The merchant receives funds from the credit card company
- The credit card company charges the merchant a fee for doing so
- The credit card company subsequently bills the consumer
- The consumer then pays the credit card company at some point in the future.
This is a form of factoring.
A Comparison to Credit Card Payment
In the commercial business world, it is possible that a company will accept credit card payment for its product or service. However, when individual transactions are in the tens of thousands, hundreds of thousands or millions of dollars the use of a credit card is not practical. Add to that the fact that most commercial customers refuse to pay cash for a product or service while demanding payment terms and you can have a cash flow problem. Consequently, the business owner needs to look for other options if he wants to get paid quickly.
Accelerated payment can be accomplished by invoice factoring. As with credit card purchases, there are three parties:
- The buyer
- The seller
- The financing company
The factoring process is very similar to the credit card payment process:
- The buyer makes a purchase
- The seller invoices the buyer
- The financing company advances cash to the seller
- The finance company charges a fee
- The buyer sends payment to the financing company based on the seller's payment terms
For consumer merchants, credit card fees can range from 2% to 5%. For commercial businesses, factoring fees can range from 2% to 5%.
Factoring is erroneously considered an "expensive" solution primarily because people use the wrong model for determining cost. They attempt to apply "borrowing" calculations to a "purchase" activity. Factoring is more aptly compared to accepting credit card payment. Used properly, invoice factoring is a reasonable and cost effective solution to a business cash flow problem.