Factoring Invoices and the Price of Cash Flow
Remember the golden rule; who has the gold rules. This is particularly true in business. Not only is having gold – or cash, as in most cases – important, but having it in hand sooner rather than later allows you more control over how it is leveraged to work for you versus against you.
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Factoring, in essence, involves discounting accounts receivable in order to get paid sooner rather than later. Discount fees can range from as low as 1% up to 3% depending upon a variety of factors including;
- The total number of invoices to be factored
- The average amount of total invoices
- The customer's stability and creditworthiness
- The average payment terms or total days before an invoice is due
- The total number and type of customer mix
Invoices due in 30 days on average, for example, may be discounted 1 to 2% versus 2 to 3% for invoices due in 60 days for normal commercial invoices.
While the term "discount" is often also referred to as "rate," it is not to be confused with rate in the context of a loan. This is a common mistake. Since factoring is not a loan, a factoring discount rate of 2% is not the same as a 2% APR on a loan. APR stands for annual percentage rate and a 2% APR suggests 24% interest per year.
A factoring invoice fee of 2% applies to a one-time fee associated with an invoice amount, versus a discount fee that is applied to the invoice amount over a series of months into the future. Also, when you factor an invoice, you are not borrowing money as is the case with a loan and the corresponding APR.
Put differently, factoring is like selling a product at a discount. The product is the invoice and the discount is the rate paid to convert the invoice into cash in hand sooner – typically 24-48 hours - rather than later when the invoice becomes due – possibly 30 or 60 days. If you were to offer a customer who bought something from you each month a routine discount of 2%, this does not translate into a total annual discount of 24% (2% x 12 months).
The ROI of Factoring Invoices
Factoring offers your business improved cash flow as well as an increased capacity to grow your business.
- Improved Cash Flow | As long as your profit margin is higher than the rate paid to factor invoices, your company is not only making money but it is improving cash flow by having cash in hand 24 to 48 hours following delivery of goods and services versus 30 to 60 days when the invoice becomes due. Having a 10% profit margin on a sale for example, means actually earning 8% when the invoice is factored at a discount of 2%.
- Increasing Growth Capacity | Once the money is in your hands, there are ways where you can now make it work better for you. For example, if your suppliers offer you a quick-pay discount, such as 2%10N30, the 2% paid to a factor is recovered by paying this invoice in 10 days.
In addition to the cost breakeven benefit between the two transactions (AR factoring and AP discounting), you also have the possession of the goods from your supplier sooner than you may have otherwise if your cash was tied up in accounts receivable. When the item supplied also represents improved capacity to support increased sales, you also benefit by advancing your capacity to grow your business. For manufacturing, the item might be production equipment or inventory supplies. For a service-based business, it could be the purchase of productivity-enhancing software or a new work station.
With a better understanding of the cost of factoring and the benefits of improved cash flow, you may now conclude that a factor rate is a small price to pay for having the working capital you need, when you need it to drive increased growth and profitability.
"...that invoice factoring with 1st PMFBancorp® helps your business to obtain working capital effectively and efficiently? For a young and/or fast growing business, this financing option can also open up access to a variety of other financial services that will take the operation to new levels of productivity and profitability. This includes accounts receivable management and collections, equipment financing, trade financing and credit insurance. For more information, contact 1st PMFBancorp toll free at 800-218-9000 or review factoring FAQs."
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Other Small Business Working Capital Learning Topics:
Working Capital Know-How | Factoring | Alternative Financing | Increasing Cash Flow | Special Finance Services
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