FACTORING COSTS
By definition, the cost of factoring is the discount rate. It is expressed as a percentage, yet different from an interest rate charged for a loan or credit line. Unlike a bank loan or credit line, a factoring company can't offer a standard discount rate since the perceived risk, funding, repayment, asset encumbrance, and many other aspects are substantially different from the banking industry. Therefore, the discount rate charged by a factoring company can only be obtained through a meaningful consultation between the client and the factoring company. However, to gain some insight into the cost of factoring, ask yourself how much of a discount would your business accept for a prompt cash payment. Most companies already offer a 1-5 percent discount for prompt payments. A factoring deal can be completed for the same or less cost than a company's current prompt payment offer. One advantage of factoring is its simplicity from a client's perspective. The client only needs to realize that factoring exists, how it works, and what is the cost. The difficult work is performed by the factoring company. It must understand the client's business and provide an equitable discount rate for the client and the factoring company. However, the factoring company needs only basic information to become interested in extending an offer and providing a quote. The list below describes some of the required information and identifies the variables that make a standard rate difficult to provide. The factoring company evaluates the following before extending an offer and quote: Customer Creditworthiness Business Requirements Performance Customer Creditworthiness The creditworthiness of the client's customers is the single most important ingredient in determining the willingness of a factoring company to extend an offer and what it will charge for its investment (discount rate). Often times factoring is dubbed too expensive by outside observers, but they fail to recognize the significant risks associated with factoring (which requires no collateral and no repayment schedule to get its money back in case of default) because they are not evaluating the customer's creditworthiness. To provide a quote without this information is a waste of time for both the client and the factoring company since it would be based on mere speculation. Therefore, at the very least, a factoring company needs to know; who are your customers, how much do they owe, when do they pay, and if they are solvent. Business Requirements (Needs) The needs of a business will also affect the discount rate. The discount rate can vary with different level of services offered by the factoring company. For instance, will the factoring agreement consist of factoring one invoice, twenty invoices, or eighty invoices once a month, every other month, or every six months? If the factoring company can mitigate its risk through a large volume of invoices or through a variety of customers, the discount rate will be lower to reflect the lower risk involved in the deal. Administration of invoices will also influence the discount rate. Generally, the discount rate includes many administration services that the factoring company offers (billing, collection, insurance, and credit), but the rate may be adjusted to reflect services rendered or deferred by the client Performance Measured by rate of return (ROI), factoring and its discount rate must provide the client with the same or reduced costs and increased revenue to effectively increase ROI. All business activities should be evaluated to determine its ROI. A factoring agreement is an activity that should only be used when a greater ROI can be obtained. The timing of cash flows (outflows and inflows) is important in determining ROI since payments in the future can erode the investment. After considering the customers and the business requirements, the factoring company must offer a discount rate that reduces or maintains costs with greater revenue and thus greater ROI. Factoring provides immediate funding to accomplish this in three areas: Sales Growth Financing - Extending credit to customers or providing better terms while maintaining cash flow through factoring will boost revenues and ROI. There are two principles applied to this strategy. First, the 80/20 principle basically states that 80% of your profits come from 20% of your revenue. Once you know your critical 20%, you can try to multiply this type of business. It's worth it --- because adding another 20% of critical revenues could add another 80% of profits. Do you have a plan to double the critical 20%? Is it working? So offering more generous terms to 20% of your critical customers will generally yield an increase in sales and revenue far beyond the cost of factoring (discount rate). Secondly, by generating more sales with the same fixed costs provides better economies of scale. This business principle states that economies of scale arise from spreading fixed costs (administration, insurance, rent, etc.) over a greater number of sales. As long as timely cash flow is maintained, the profitability of each sale increases and returns a greater ROI. Minimizing accounts receivable and maximizing ("stretching") accounts payable - A business is provided with an opportunity to do either or both to increase ROI through a factoring agreement, even with lengthy credit terms. Minimizing accounts receivable (getting paid as soon as possible) lessens the effect of payments spread out over time. Payments in the future can erode ROI and inhibit a company from completing more business today. Factoring provides immediate funding that gives the business options. It gives the business the option to take advantage of the standard prompt payment discount (2%/10 days, net 30). If your company is unable to take advantage of the standard prompt payment discount and are paying suppliers in full because of slow paying customers or lengthy credit terms, then the company is essentially loaning the supplier money at 37% per annum. By using the funds provided through factoring, the prompt payment discount can be used to effectively reduce costs. Another option is to "stretch" or maximize accounts payable through factoring. Using the immediate funding factoring provides and the time before payment of certain bills allow funds to be retained in an interest bearing account to reduce costs and increase ROI through accumulated interest. Time Value Of Money - While great revenue can be generated through large projects/contracts, a company should consider the timing of the cash outflows and inflows that occur in the period specified by the contract to determine ROI. Usually, larger projects/contracts call for longer payment terms or greater pressure on cash flow. Payments in the future can erode ROI and induce cash flow problems. Factoring can manipulate costs and revenues, while considering the time value of money, in such a way to increase ROI. Simply, many companies could not obtain the increased revenue and greater ROI without factoring to offset payments occurring in the future. A specialized factoring company that understands the construction industry can provide an equitable discount rate. Only after consideration of many aspects is the true cost of factoring realized. Can you afford not to factor? FINALLY To accurately compute the cost of factoring and the profit from factoring, you must consider the full spectrum. This is especially true when comparing factoring to borrowing. It is rare that companies decide not to factor because they could not afford factoring. As a matter of fact, most companies factor because they can't afford not to! |
ACCOUNTS RECEIVABLE PURCHASING FACTORING QUESTIONS AND ANSWERS DEBITOR-IN-POSESSION FINANCING
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