Overruled: The Cost Objection to Factoring Account Receivables

Factoring account receivables is often maligned by media pundits and supposed business financing experts as the worst method of financing a business. Their number-one criticism of receivables factoring is its costs when compared to the interest rates charged by banks and commercial lenders. Anyone with a basic understanding of business factoring knows that on an annualized basis, the discounts are higher than loan interest charged by banks. But this comparison falls short on many levels, and misses one critical point entirely:

What does it cost a business to not factor receivables?



Objection Overruled:
Factoring Account Receivables Costs Too Much

The market interest rates charged by commercial lenders are always used to support the argument that receivables factoring costs too much. The problem with this assertion? It’s just plain invalid.
  • Receivables factoring is NEVER a loan,
  • There are NO liabilities created on the balance sheet, and
  • There is NO interest charged.
Factoring account receivables is transaction based. Factoring companies do not extend credit to their business clients, rather they buy individual invoices at a discount (typically between 2 and 3 percent). Once each invoice is paid, the factoring company deducts its discount from the reserve and sends the balance to the client to complete the transaction.

Factoring invoices is similar to offering a cash discount or early pay discounts (for example, the “two net ten”), which means that if the invoice is paid within the first 10 days, the customer can take 2% off the invoiced amount.  Businesses that accept credit cards routinely pay a 2-3 percent “merchant fee” (in reality, a discount) to the credit card companies to get their funds.

Business Financing Tip

Are you are already offering an early payment discount?

Why not let a factoring company take that discount (make that fee) and give you your money in 1 day rather than 10 days?

Critics of receivables factoring often simply multiply the discount fee by 12 months to compute an annualized rate, which they routinely compare to the nominal interest rates of commercial lenders. The discount for factoring invoices is not comparable to the interest rate on a loan because it is not a loan – any more than two net ten discount or a credit card merchant fee.

Consider the simple example of a small office furniture store with an average 30 percent gross profit margin across a range of typical office furnishings. A smiling customer walks up to the counter to order more desks and chairs than you generally sell in a year, then asks you to invoice his company. Your gross profit margin is 30 percent but you will have to order and pay for the desks and chairs to fill the order, and then wait for 30 days to receive your money.

Your options:
  • Accept the order and sell the invoice at a 2% discount. You will gross 28% (your 30% profit margin minus the 2% factoring fee) and have 80% of the invoiced amount in your business bank account tomorrow.
  • Refuse the customer’s request and forfeit the 28% profit on a year’s worth of desk and chair sales.

Many factoring companies offer purchase order financing – basically, a cash advances on purchase orders your firm receives – giving you working capital financing to purchase supplies and labor to complete the orders.

The choice is a simple one, right? And the flaw in the “costs too much” argument against factoring account receivables is exposed. You will make an entire year’s worth of desk and chair sales in one transaction and pay a 2% transaction fee just as you would have if you accepted a credit card from your customer. This is not in any way comparable to paying a 24% interest rate on a loan, since you are not borrowing the money to finance the desks, chairs and your 28% gross profit for a year. 

Consider how your company could increase its profits through receivables factoring – not the 2% discount. Unrealized income and missed opportunities clearly cost your firm much more. Factoring account receivables may also allow you to take advantage of savings you might not otherwise get to enjoy. For example, you could eliminate late payment fees and take advantage of early payments to your suppliers and other vendors.

And when you factor your receivables, you no longer have the burden and expense associated with their collection and bookkeeping or performing credit checks on your customers. You eliminate some of the costs and problems associated with late payment, bad checks, and bad debts. Factoring companies manage all of this for you as part of their service, making them not just a financial partner, but also an extension of your business.

You Be The Judge

Does receivables factoring cost too much?

When factoring account receivables is fully understood, it is very rare that a company will decide not to factor because it costs too much. In fact, most smart business owners get into a factoring program because they know they can’t afford not to. When viewed through this lens, receivables factoring is not a cost at all. With this business financing power tool, you gain peace of mind, time, and money to enjoy your life and grow your business.

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