Factoring is not a lending service. It is a discounted purchase. A factor typically does not charge interest. A factor simply buys invoices at a discount and collects a fee.
Many businesses that apply for bank financing, especially small to mid-sized companies, are turned down. Banks must follow very rigid guidelines established by the FDIC. They are required to maintain a certain level of capital or equity in order to lend out money. When evaluating a loan application, banks must consider the amount of assets that a business has to secure the loan. Those assets are called collateral. Banks generally require a great deal of collateral to secure a loan for a business.
Factors, on the other hand, are not subject to the same regulations that banks are, because factoring is an outright purchase, not a loan. Factors may advance up to 90 percent or more of a business’s accounts receivable.
Banks base their financing on the strength of the business applying for the loan, not on the business’s accounts receivable. Even if a business’s customers have solid and reliable credit, the bank still will not give a client a loan unless the client’s business has a strong financial statement independent from the accounts receivable.
Common Misconception
Too often potential clients will begin the factoring decision by looking at factoring discounts (percentages) on an annualized basis, like a car loan or a mortgage.
They take the 4% they are may be quoted, annualize it (multiply by 12) and gasp thinking that they are charged a 48% interest! However, we deal in short-term funding, where an average invoice pays in 42 days.
As comparison; look at the 2% discount a business would offer a client for quick payment in 10 days of a similar invoice. That 2% discount is for payment in 10 days. In a year there are thirty-six 10-day periods--------using the annualized percentage parallel, "that's 72% interest! Are they paying 72% for quick payment? No, and factors don't earn 48% for funding, either.
Why? Because factoring is short-term paper.
To compare it to a long-term note is like comparing apples to oranges. In the end, the decision to factor always comes down to a business decision. If this money is going to cost 4%, can you take the money generated by factoring and earn more than 4%? After all, nobody factors just to have the money in their checking account.
Why Chose Factoring?
Most businesses must weigh the costs of factoring against the costs of not doing it. Most often the decision is between factoring and putting up with cash flow problems.
If you are missing out on sales opportunities because of a lack of cash flow, be sure to consider that lost revenue when weighing the costs of factoring. Consider what increases in profits you can achieve with additional cash flow.
For example, if in your current situation, without factoring, you have gross revenues of $100,000 a month. Your cost of goods is 65% resulting in gross profits of $35,000. Subtract overhead at 32% ($32,000) and you are left with a net profit of $3,000.
Now, consider what additional cash flow would enable you to do, such as take additional discounts for volume purchases, increase your sales and advertising effort, or add a second shift. By factoring the first $100,000 in receivables, you can project a doubling of revenue to $200,000 with a consistent 65% cost of goods (although this may actually come down depending on if you can receive discounts for paying in cash). This puts your gross profit at $70,000. Subtract overhead of $44,000 (which is more, but never double) and the cost of factoring----$6,000----and you are looking at a net profit of $20,000.
So how expensive is factoring?
In this instance, which is more typical than not, the decision not to factor would have cost you $20,000 in missed opportunity for one month. So how expensive is factoring?
To accurately figure your profit margin with factoring, you must take into consideration the full spectrum of services offered. This is especially true if you are comparing factoring to borrowing then you are probably on sound ground. If you are looking to use the proceeds of factoring to pay overhead, to clean up bad debts, to pay past due cost-of -goods invoices, then you need to look carefully at what you are doing. Will this increase your chances of growing and expanding?
It is rare that companies decide not to factor because they could not afford to. As a matter of fact, in most cases, companies decide to factor because they can't afford not to.
Is Factoring For You?
The key to knowing if factoring is for you is to not to look only at the bottom-line factoring fee, but also to consider how your company may increase its profits through factoring.
The following are additional information on factoring to help you with your decision:
Fees and advance rates are determined based on several factors:
- The creditworthiness of your clients
- Your monthly billing volume
- Average invoice size
- Average days to payment
What is an advance?
The amount of money you receive immediately when we buy your invoice. The balance is returned to you when your customer pays the invoice. Advances range from 60-95% of the invoice's face value. For example if the invoice's value is $1,000 an advance rate of 80% equals $800. The balance of $200 less the factoring fee is returned to you when your customer pays the invoice.
Comparing Bank Lending Rates to Factoring?
When compared to bank lending rates, factoring initially appears to be very expensive. Here are five typical questions/concerns that are raised by potential factoring clients
- Wow! 3 points per month! That's 36 percent year!
It is tempting to annualize the numbers, but that is an "apples and oranges" comparison. Banks loan money at an annualized interest rate, 12 percent per year for example. Factors purchase your receivables at a discount. The products are different and there are other inconsistencies to this inappropriate comparison.
The bank provides the money only one time, the day that you receive the loan; factors provide money continuously. As an example, consider a bank loan for $100,000 at 12 percent. You receive the $100,000 just one time and then pay $1,000 interest per month and you still owe the $100,000. Or the bank could provide you with a line of credit that you use only when you need the money but the bank is charging you for that privilege and if you need to increase your line you need to go through the qualifying process all over again.
When you factor $100,000 each month for a year you have the use of $1.2 million (12 x $100,000) over the year. Unlike a bank loan where you have just $100,000 one time. Assuming a 3-point discount, the fees over the year will be 12 x $3,000 or $36,000, which is still 3 percent of $1.2 million. And at the end of the year you have no debt!
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I'm only making 3% profit, how can I pay you 3 points?
A company making only 3% net profit can do more business volume as a result of factoring, and the larger volume will result in a higher profit margin because fixed costs do not increase with volume. The added business at a higher marginal profit leads to an increased overall profit margin. As the volume increases, the cost of production decreases, so that profits increase. Fixed costs i.e., rent, electric, insurance, etc., increase very little or not at all with volume. An increase in business will not affect rent. Electric bills may rise slightly. Workers compensation insurance may rise slightly. These costs do not increase as do direct production costs.
Let's graphically do the math assuming you can double your sales.
Without Factoring
Monthly Gross Sales
$50,000
Cost of Goods Sold
$30,000
60% of Gross Sales
Monthly Gross Profit
$20,000
40% of Gross Sales
Fixed Expenses
$10,000
Variable Expenses
$8,500
17% of Gross sales
Factoring Fee
N/A
Total Expenses
$18,500
37% of Gross Sales
Monthly Net Profit
$1,500
3% of Gross Sales
With Factoring
Monthly Gross Sales
$100,000
Cost of Goods Sold
$60,000
60% of Gross Sales
Monthly Gross Profit
$40,000
40% of Gross Sales
Fixed Expenses
$10,000
Variable Expenses
$17,000
17% of Gross Sales
Factoring Fee
$3,000
3% Fee
Total Expenses
$30,000
30% of Gross Sales
Monthly Net Profit
$10,000
10% of Gross Sales
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But I only get 80% of my money upfront!
Let's assume an advance rate of 80%. Let's also assume that you begin factoring in January. You have factored $100,000, a factor pays you $80,000 of that money upfront, with the remaining money making up the fee (3%) of $3,000 and the reserve (17%) of $17,000.
Now in February, you once again factor $100,000 and receive $80,000. However. you also receive your January reserve of $17,000(assuming your customer pay in 30 days). So for February, you actually receive 97% of your money, instead of 80%. In the second month and going forward you are basically receiving 97% of your cash flow.
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But what if my customers take longer than 30 days to pay?
You have several options; Assume your client takes 60 days to pay. You bill your client in the normal fashion and simply allow 30 days to go by prior to factoring that invoice. That way you pay the 30-day fee. Another way is to factor your faster customers first for the cash you need.
