When discussing invoice factoring with referral partners and
prospective customers they frequently attempt to compare the cost of
money through factoring to the cost of money through bank lending. This
is a comparison that is not easy to make because the processes are so
very different.
The following is a good way to explain the difference.
Comparison to Early Payment Discount
The
most direct comparison for Invoice Factoring is the early payment
discount offered by many companies to their customers. Traditional early
payment terms are 2/10 Net 30. This means that the customer can take 2%
off the face value of the invoice if they remit payment within 10 days
of receipt of invoice. Otherwise they must pay the full price in 30
days.
This is precisely what Invoice Factoring does without
offering the end customer the option to take the discount. There are
advantages to taking this approach. One is that end customer does not
get accustomed to the idea of a discount. Therefore, when a business no
longer needs to factor its invoices that 2% goes directly to the bottom
line.
Here's another reason that factoring makes good sense. Some
companies will insist on taking an offered 2% discount and pay in 30
days anyway. This completely destroys the purpose of offering the
discount.
Factoring eliminates these two negative ramifications.
Comparison to Accepting Credit Card Payment
At
its most basic level, invoice 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 (and some commercial transactions) this is done by accepting
payment by credit card. The Merchant Processing Fees charged for credit
card payment range from 1.75% to 4% of transaction value. The type of
card, bank, volume, etc., impact the actual transaction fee.
Square,
for example, has a 2.75% fee for each transaction. [Square is the
company that makes it possible to convert a cell phone, tablet or
computer into a credit card processing device.]
Invoice Factoring
is also a transaction based process. On a typical invoice factoring
transaction, the service fee would be between 2% and 2.5% (depending on
the specifics of the transaction). That's less than taking payment by
credit card.
Comparison to Bank Lending
The
difference between factoring and bank lending is the difference between
buying and renting. Bank lending is a rental fee. When you borrow from a
bank (or access funds from a line of credit) you must pay those funds
back in full, plus a little extra. That extra is the interest rate. This
is similar to the fee you pay for renting a car. Once you're done with
the unit you must return it and pay for the privilege of usage. So it is
with a bank loan. You have the privilege of using the bank's money but
must give it back when done and pay for the use.
In Invoice
Factoring you have not borrowed money so you have nothing to pay back.
You have sold an asset to the factoring company - an invoice that's part
of your company's Accounts Receivable. (Typically there are multiple
unpaid invoices in the A/R report at any one time.) That asset (the
invoice) requires that your customer honor their obligation to pay for
product and/or service. Thus the factoring company gets its money back
when your customer honors that obligation.
Converting a discount
rate (for example, the early payment discount noted above) to an
interest rate is a unique calculation. It is not straight forward.
Multiplying the discount rate by 12 months does not reflective the true
cost of money because the "discount" is applied against revenue, not
against a static borrowed amount. An interest rate, on the other hand,
is applied against a borrowed amount.
For example, let's assume
$100,000 in invoices sold to the factoring company each month. Let's
further assume a discount rate of 2.5% on each invoice. [That, by the
way, is on the high side.] In a year's time $1,200,000 in future revenue
would be sold to the factor. The cost of money would be $30,000 [2.5%
of $100,000 = $2,500 x 12 = $30,000].
To calculate a comparative
value for borrowed money you should take the interest rate of the
lender's offer and multiply it by $1,200,000. Here's how that looks. The
Lending Club (for example) recently advertised a rate "as low as" 5.9%
per year interest. At 5.9%, on $1.2 million the cost of borrowed money
would be $70,800 per year. If that revenue were factored the cost of
money would be $30,000.